One of my friends writes some interesting stuff that is being written nowadays about investing, is fond of using the word fool. But he doesn’t do it the normal way – the way, say, a school teacher does. For example, I remember him once saying that banks were the default suppliers of foolishness in the markets. This idea of foolishness in this special sense makes it easier to understand why markets behave the way they do. What exactly is this foolishness? I think it’s best defined as what is not.

barros-money-man.jpgWe’ve all heard of the Efficient Market Hypothesis, which says that financial markets are ‘efficient’, meaning that the prices of stocks (or other securities) reflect all known information and therefore incorporate the collective beliefs of all investors about the future. For the hypothesis to be correct, people must have equal access to all information and have rational expectations.

I think the kind of foolishness we are talking about is everything that is the opposite of all those factors that make the market efficient. It’s a bit like heat and cold in physics. You could say that the flow of knowledge and rational expectations keep the markets efficient or you could say that it’s the flow of foolishness that keeps the markets inefficient. Isn’t that a problem? No, it isn’t, most certainly not. Inefficiency is what keeps the stock market interesting and profitable. If the markets were as efficient as the hypothesis says, then those who can identify and mark out foolishness would make less money.

Therefore, a steady and limitless supply of foolishness is the greatest of assets. Foolishness is the life blood of the stock market. Without foolishness, we would be nowhere. Instead of worrying about how well companies are doing and how much the economy is growing, smart stock investors should instead worry about whether an adequate supply of foolishness will be maintained. I’m happy to inform readers that if present trends continue, they have nothing to fear.

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It’ll take just a few examples for me to convince you that my optimism about the future of foolishness is well-founded. One crucially important observation I made was that the most promising suppliers of foolishness use a different calendar than the rest of the country. I met people who thought the term ‘long-term’ in long-term investing meant six months. I also met those who thought it meant three months and some who thought it meant one month. These are not isolated examples, there are a large number of people whose country use such calendars. However, the definition of long-term that gave me most hope was, “When there are profits it’s short-term, when there are losses it’s long-term”.

Don’t ask, I don’t know what that means either.