Searching for Rational Investors: Explaining the Lowenstein Paradox

I. INTRODUCTION

Louis Lowenstein has been one of the most articulate and consistent critics of the academic hypothesis that our securities markets are, for the most part, extraordinarily efficient. In this article, he makes two important points. First, he argues that the enormous bubble in high-tech stock prices around the turn of the century effectively demolished the efficient market hypothesis: "If the NASDAQ Composite Index, for example, was right at 1200 in April 1997, it surely wasn't right at 5000 in March 2000, and then right again at 1100 two years later."1 Lowenstein goes on to argue that a number of so-called "value" investors (those who look for stocks with reasonable prices relative to their earnings, dividends, and asset values) were smart enough to eschew the high-tech market favorites of the period; as a result, they earned generous rates of return, even during periods after the bubble popped. Unfortunately, Lowenstein opines, there were not enough of these "value" investors to make market prices in general consistent with proper estimates of their true value.