If the markets are irrational, then don’t rationalize yourself out of profit: The inefficient market hypothesis

I think the entire premise of an efficient market is a farce. Markets are large gatherings of people. People are irrational, and the combination of a bunch of irrational people does not result in something rational. Therefore makets are irrational. That’s my argument in a few sentences, but here’s more detail on why I hold that belief:

Prices change every day. If prices change every day, then the prices are always wrong. I think people try to rationalize the markets by saying there is some theoretical fair price for an asset that they aspire to figure out. Others won’t even call it theoretical, they’ll just say they’re valuing the asset and there is a correct or plausible range of valuation for where the asset should be. I think this over extrapolates and fails to take the market as it is. I don’t believe in such a thing as a theoretical fair price. I believe in human behavior.

Nonetheless, the idea of a theoretical price is very appealing to many people, it’s how they approach the market. I used to believe in it myself. But such a thing doesn’t exist. It exists in our thoughts, not in reality. Often, people will say an asset ought to be worth $X as opposed to $Y. X is sometimes an exact number but often is a narrow expected range of values. This presumes that there is some theoretical price that is a true value for the asset and that the person has a better idea of it than the market and that the market will collectively come to the realization that that price is correct.

In reality though, I think that what actually happens is people’s expectations (and often emotions) change. Prices bake in people’s expectations of the future which is dependent on the actions of irrational people. This creates issues: 1, the very thing we’re trying to predict is based on irrational behavior. (The war driving oil prices today is irrational behavior, people choosing certain brands over others is often irrational, etc) 2 our expectations of the future are also irrational (even though people attempt to be rational). As a result, I think the framing of “I’m trying to predict what the price should or will be” is wrong. Framing the markets in that way certainly can and does work for many people, but I think it overextrapolates / attempts to rationalize something that’s not actually happening.

For example, when we look at an option price, we consider the probability that an underlying asset’s price will move to a certain point. That presumes that there is a probability, even when the underlying asset truly is moved by irrational actors. Maybe your option expires in the money because someone else decided to make a trade that pushed the price in your favor. That trade could’ve been made on a pure whim. Or maybe it could’ve been made on deep research. It could’ve also been made on entirely misinformed research. Regardless, your option expiring in the money was not necessarily a reflection of a true divine price moving to where it should be or a coin being flipped and landing in your favor. People acted in a way that benefitted your position.

As another example, look at the S&P’s dividends. If you discount the future dividends back and try to to try and get a true valuation for some point in the past as is theoretically correct, we see that the price does not match the “true value”. It goes all around above and below it. (There’s a cool YouTube video that shows this) So the presumption of finding the true value is provably false.

When prices change, it’s because people change the way they’re thinking about something and they act on that. I think this framing is a bit more freeing for how you can find “inefficiency” in the market. In fact, under this framing I wouldn’t really even call things efficient or inefficient. There is really no such thing because there’s no efficient price. Rather, the way you can make money in the markets is by predicting people’s behavior. As I said before, prices are people’s expectations of people’s future actions. Under my framework, you can predict people’s expectations, predict the underlying actor’s future actions, or ideally both.

And to do that you can, 1 try to gather information that the market doesn’t widely have in order to inform a better expectation. 2 Have a better interpretation / expectation of the information that the market sees. 3 Have a good understanding of how the irrational actors in the market behave and predict their behavior / reactions.

The interesting thing is, even people who are trying to get a “true value” are actually approaching things in my frameowrk. If you’re doing a DCF for example, you’re probably not going to put in assumptions that make your price 50% of what the market’s price is. You’re going to make your assumptions somewhat based on the markets current valuation as a prior and make changes based on your observations and beliefs. If the output comes out as “my valuation is 50% of what the market has right now”, you’ll probably think you need to make revisions to your assumptions. I know this because in a modeling class I took this is what happened live in an example with the professor, the model spat out a valuation a bit too far from the market value and he revised his assumptions to get a bit closer and in a more reasonable range. What this example illustrates is that even though we’re just looking at fundamentals and have some beliefs about a company which should give us a hard set valuation, the way people think about price / valuation is dependent on the beliefs of the market and how we think the market will reasonably change its beliefs in the future. A stock is very unlikely to drop 50% in a second because the true value has been revealed, lots of moves happen over the course of long periods of time. So of course a DCF outputting -50% is unreasonable because you’re probably not going to see that any time soon. But then why do we have the guise of computing a fair value in the first place?

In my mind, a DCF is actually tool to try and understand future expectations. People may use it and say they think the price should be around $X, but truly they are judging where they think expectations may move instead of actually getting a “true valuation”. They say or believe they’re getting in a reasonable range of a “true valuation”, but I argue they’re over extrapolating the truth of what they’re doing. They’re predicting future expectations.

From my perspective, I also argue DCF is an inefficient tool to approach the markets with. I think it’s too time consuming and complex for the actual goal of predicting people’s future expectations / behavior. It doesn’t take a DCF or rocket science to know that if revenue growth beats cost growth the stock price is going to go up. I’d rather spend my time trying to figure out if revenue growth is going to outpace cost growth. Another example: if a company sells off super sharply and I think people are overreacting / being overly fearful, I don’t need a DCF to tell me that. I can already tell just by how people are talking about it and my own convictions in what’s happening to the company. The markets aren’t valuation machines, they’re people. That’s why when the markets overreact to new information, prices can still reflect that overreaction for weeks or months on end.

If you’re in the markets and you think you’re predicting valuation, I think you’re deluding yourself. I think you’re truly predicting human expectation and behavior, and framing it in this less assuming way can make market understanding and prediction easier and more profitable. Look at valuation today for example, I see a load of total bullshit. Record high IPO (and upcoming IPOs) for companies that will never return anywhere close to their valuation back to shareholders. S&P valuation super concentrated in like 7 stocks. These are very obvious indicators of market fervor / a bubble which can’t last forever. From a pure valuation perspective, there is no reason to own anything in the market today. And yet we’re still here. Sky high valuations for piles of dog crap.

A famous market adage goes “buy when everyone else is selling and sell when everyone else is buying”. This adage illustrates my point and also points to the fact that it isn’t novel. People know that the human nature of markets make it irrational, and yet many will still try to rationalize it or their approach. I think this is a way of coping with the truth.

Now, I’ll share a personal lesson I’ve learned. Over the past year, I thought AI was a bubble (since summer of 2025). Seeing the way people talked about it and looking at how I used it myself, it seemed ridiculous that AI was going to revolutionize society and change the world. Basically, people were and still are saying the following: “This time, the new technology is different! It’s not like all the other times.” Now here was my mistake. If you think you’re anywhere near the beginning of a bubble, then you should actually lean into it. I thought market fervor would persist and it did, yet at the same time I stayed out of the market because I was scared. I believed if I bought in, I was buying in above “fair value” which I didn’t like. And given that I believe we’re in a bubble, I was also scared of a correction making me lose lots of money. Looking back, I think I was overly fearful. First of all there is no fair value that the market SHOULD be at. Second, bubbles inflate over long periods of time, and they pop over long periods of time (look at 2008 and the dot com bubble). Should I have been scared of the prices the market was at last summer? God no. I should have acted based on where I expected other people’s expectations and emotions to go.

All this is to say that I think success in the market is predicting people, not prices. The idea of predicting prices is an over extrapolation of our reality, everyone is predicting people whether they admit or believe it. If we’re being intellectually honest with ourselves, we should take the market for what it is, a big group of irrational people / behaviors. Rational or efficient markets would not exhibit the behaviors we see in our markets.

If the markets are irrational, then don’t rationalize yourself out of profit.