The efficient-market hypothesis (EMH) assumes that investors have “rational expectations.” This is the idea that, on average, the population is correct and whenever new information appears, expectations are updated appropriately.

Wonderful in theory, but in the real world investors are anything but “rational.” As human beings, we tend to over react to new information, behaving in an irrationally exuberant or irrationally despondent fashion (for our own research on a market inefficiency, click here).

A clear example of this irrational behavior was on full display last December.

As I wrote at the time, with the announcement of U.S. policy changes toward Cuba, investors scrambled for ways to “play it.” Their vehicle of choice quickly became the Herzfeld Caribbean Basin Fund, a closed-end fund with the ticker “CUBA.” In the course of a week, the fund more than doubled in a vertical move higher accompanied by a substantial increase in volume.

While the ticker was “CUBA,” there was no actual Cuban companies in the fund’s holdings, only companies that “might benefit” from a shift in policy towards Cuba. This minor detail did not matter. Investors bid up shares in CUBA to an astounding 70% premium over net asset value.

In an efficient market, such a wide divergence would never happen, as arbitrageurs would have stepped in, shorting the fund while buying the underlying holdings to earn a “riskless” profit. In an efficient market, no investor would have chosen to buy CUBA at a 70% premium when they could buy the underlying holdings at no premium at all.

But the market is not entirely efficient and it took a year for the price of CUBA to move back to its NAV. Yesterday, it closed at $6.45, slightly below its NAV of $6.53.

The lesson here is as old as time. The markets are far from efficient and a key reason for that is that investors are far from rational. The CUBA fund is merely one example. It has happened before and it will happen again as long as human behavior is a driving force in markets.