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Searching for Rational Investors In a Perfect Storm By Louis Lowensteinn

Abstract In October, 1991, there occurred off the coast of Massachusetts a “perfect storm,” a tempest created by a rare coincidence of events. In the late ‘90s, there was another perfect storm, an also rare coincidence of forces which caused huge waves in our financial markets, as the NASDAQ index soared, collapsed, and bounced part way back.

What had happened to the so-called “rational” investors, the smart money, whom economists have for decades said would keep market prices in close touch with the underlying values? Despite the hundreds of papers on markets and their efficiency, it is a remarkable fact that no scholar, not one, has looked to see who are these rational, i.e., value, investors, how they operate, and with what results.

I decided to see how a group of ten value funds, selected by a knowledgeable manager, performed in the turbulent boom–crash–rebound years of 1999-2003. Did they suffer the permanent loss of capital of so many who invested in the telecom, media and tech stocks? How did their overall performance for the five years compare with the returns on the S&P 500?

For most managers, mimicking the index, it was difficult not to own Enron, Oracle and the like, but the ten value funds had stayed far away. Instead, they owned highly selective portfolios, mostly 34 stocks or less, vs. the 160 in the average equity fund. Reflecting their consistent and disciplined approach, they turned their portfolios at one-sixth the rate of the average fund. Bottom line: every one of the ten outperformed the index over the five year period, and as a group they did so by an average of 11% per year, the financial equivalent of back-to-back no-hitters.

The article closes with a discussion of the clearly large implications for investors, market watchers and public policy. As for those economic models, let the chips fall where they will.


In October 1991, there occurred off the coast of Massachusetts a “perfect storm,” a tempest created by a rare combination of events, primarily an Arctic cold front colliding with a

1 Rifkind Professor Emeritus of Finance & Law, Columbia University; member of Panel on Audit Effectiveness, created at the instance of SEC Chairman Arthur Levitt, 1998-2000; director Institutional Inv. Project, Columbia Law School, 1986-94. My thanks to Andrew Larrick of the Law School Library and Kevin P. Laughlin of the Vanguard Group, for their unstinting research help. Special thanks to Roger Lowenstein for his insights and editing, not once but twice.


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