Inefficient Markets Are Still Hard to Beat

Thus, it's important not to draw the wrong conclusions from the market's inefficiency. “The evidence does suggest that the market is not rational,” says Meir Statman, a finance professor at Santa Clara University in California. “But watch out for the voice of the devil inside of you saying that therefore it must be easy to beat the market.”

For one thing, hindsight blinds you to the truth. Last March, in the bowels of global financial panic, it was far from clear that Bank of America would survive and that the stock was dirt cheap.

The market had priced such companies as if they might go out of business because plenty of information suggested that was a possibility, and because fear was then so pervasive that optimism felt almost like a form of irrationality.

So, while it may seem obvious today that Bank of America is a survivor, most investors didn't think the market price for the stock was too cheap last March. As Prof. Statman puts it: “The market may be crazy, but that doesn't make you a psychiatrist.”

Looking back at how cheap stocks got last spring, you may conclude that any idiot should have known to be buying them hand over fist. But mutual-fund investors sold out of stocks all year long; in March alone, at the very moment when stocks were cheapest, fund investors dumped $25 billion worth.

Furthermore, money managers chase whatever's hot and shun whatever's not. Those who are the best at this game attract more money in rising markets and lose fewer clients in falling markets, pushing prices further away from Mr. Graham's “investment value.” These are the last people who will go against the grain to buy cheap stocks at the bottom.