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You Can't Become Rich In Your Pocket Until You Become Rich In Your Mind | ||||
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Mutual funds, although less volatile than individual stocks, also display a disregard for analysts pronouncementsChance and Efficient Markets If the movement of stock prices is random or near-random, then the tools of technical analysis are nothing more than comforting blather giving one the illusion of control and the pleasure of a specialized jargon. They can prove especially attractive to those who tend to infuse random events with personal significance. Even some social scientists dont seem to realize that if you search for a correlation between any two randomly selected attributes in a very large population, you will likely find some small but statistically significant association. It doesnt matter if the attributes are ethnicity and hip circumference, or (some measure of) anxiety and hair color, or perhaps the amount of sweet corn consumed annually and the number of mathematics courses taken. Despite the correlations statistical significance (its unlikelihood of occurring by chance), it is probably not practically significant because of the presence of so many confounding variables. Furthermore, it will not necessarily support the (often ad hoc) story that accompanies it, the one purporting to explain why people who eat a lot of corn take more math. Superficially plausible tales are always available: Corn-eaters are more likely to be from the upper Midwest, where dropout rates are low. Geniuses, Idiots, or Neither Around stock market rises and declines, people are prone to devise just-so stories to satisfy various needs and concerns. During the bull markets of the 90s investors tended to see themselves as perspicacious geniuses. During the more recent bear markets theyve tended toward self-descriptions such as benighted idiots. My own family is not immune to the temptation to make up pat after-the-fact stories explaining past financial gains and losses. When I was a child, my grandfather would regale me with anecdotes about topics as disparate as his childhood in Greece, odd people hed known, and the exploits of the Chicago White Sox and their feisty second baseman Fox Nelson (whose real name was Nelson Fox). My grandfather was voluble, funny, and opinionated. Only rarely and succinctly, however, did he refer to the financial reversal that shaped his later life. As a young and uneducated immigrant, he worked in restaurants and candy stores. Over the years he managed to buy up eight of the latter and two of the former. His candy stores required sugar, which led him eventually to speculate in sugar markets and-he was always a bit vague about the details-to place a big bet on several train cars full of sugar. He apparently put everything he had into the deal a few weeks before the sugar market crashed. Another version attributed his loss to underinsurance of the sugar shipment. In any case, he lost it all and never really recovered financially. I remember him saying ruefully, Johnny, I would have been a very, very rich man. I should have known. The bare facts of the story registered with me then, but my recent less calamitous experience with WorldCom has made his pain more palpable. This powerful natural proclivity to invest random events with meaning on many different levels makes us vulnerable to people who tell engaging stories about these events. In the Rorschach blot that chance provides us, we often see what we want to see or what is pointed out to us by business prognosticators, distinguishable from carnival psychics only by the size of their fees. Confidence, whether justified or not, is convincing, especially when there arent many facts of the matter. This may be why market pundits seem so much more certain than, say, sports commentators, who are comparatively frank in acknowledging the huge role of chance. Efficiency and Random Walks The Efficient Market Hypothesis formally dates from the 1964 dissertation of Eugene Fama, the work of Nobel prizewinning economist Paul Samuelson, and others in the 1960s. Its pedigree, however, goes back much earlier, to a dissertation in 1900 by Louis Bachelier, a student of the great French mathematician Henri Poincare. The hypothesis maintains that at any given time, stock prices reflect all relevant information about the stock. In Famas words: In an efficient market, competition among the many intelligent participants leads to a situation where, at any point in time, actual prices of individual securities already reflect the effects of information based both on events that have already occurred and on events which, as of now, the market expects to take place in the future. There are various versions of the hypothesis, depending on what information is assumed to be reflected in the stock price. The weakest form maintains that all information about past market prices is already reflected in the stock price. A consequence of this is that all of the rules and patterns of technical analysis discussed in chapter 3 are useless. A stronger version maintains that all publicly available information about a company is already reflected in its stock price. A consequence of this version is that the earnings, interest, and other elements of fundamental analysis discussed in chapter 5 are useless. The strongest version maintains that all information of all sorts is already reflected in the stock price. A consequence of this is that even inside information is useless. It was probably this last, rather ludicrous version of the hypothesis that prompted the joke about the two efficient market theorists walking down the street: They spot a hundred dollar bill on the sidewalk and pass by it, reasoning that if it were real, it would have been picked up already. And of course there is the obligatory light-bulb joke. Question: How many efficient market theorists does it take to change a light bulb? Answer: None. If the light bulb needed changing the market would have already done it. Efficient market theorists tend to believe in passive investments such as broad-gauged index funds, which attempt to track a given market index such as the S&P 500. John Bogle, the crusading founder of Vanguard and presumably a believer in efficient markets, was the first to offer such a fund to the general investing public. His Vanguard 500 fund is unmanaged, offers broad diversification and very low fees, and generally beats the more expensive, managed funds. Investing in it does have a cost, however: One must give up the fantasy of a perspicacious gunslinger/investor outwitting the market. And why do such theorists believe the market to be efficient? They point to a legion of investors of all sorts all seeking to make money by employing all sorts of strategies. These investors sniff out and pounce upon any tidbit of information even remotely relevant to a companys stock price, quickly driving it up or down. Through the actions of this investing horde the market rapidly responds to the new information, efficiently adjusting prices to reflect it. Opportunities to make an excess profit by utilizing technical rules or fundamental analyses, so the story continues, disappear before they can be fully exploited, and investors who pursue them will see their excess profits shrink to zero, especially after taking into account brokers fees and other transaction costs. Once again, its not that subscribers to technical or fundamental analysis wont make money; they generally will. They just wont make more than, say, the S&P 500. (That exploitable opportunities tend to gradually disappear is a general phenomenon that occurs throughout economics and in a variety of fields. Consider an argument about baseball put forward by Steven Jay Gould in his book Full House: The Spread of Excellence from Plato to Darwin. The absence of .400 hitters in the years since Ted Williams hit .406 in 1941, he maintained, was not due to any decline in baseball ability but the reverse: a gradual increase in the athleticism of all players and a consequent decrease in the disparity between the worst and best players. When players are as physically gifted and well trained as they are now, the distribution of batting averages and earned run averages shows less variability. There are few easy pitchers for hitters and few easy hitters for pitchers. One result is that .400 averages are now very scarce. The athletic prowess of hitters and pitchers makes the market between them more efficient.) There is, moreover, a close connection between the Efficient Market Hypothesis and the proposition that the movement of stock prices is random. If present stock prices already reflect all available information (that is, if the information is common knowledge in the sense of chapter 1), then future stock prices must be unpredictable. Any news that might be relevant in predicting a stocks future price has already been weighed and responded to by investors whose buying and selling have adjusted the present price to reflect the news. Oddly enough, as markets become more efficient, they tend to become less predictable. What will move stock prices in the future are truly new developments (or new shadings of old developments), news that is, by definition, impossible to anticipate. The conclusion is that in an efficient market, stock prices move up and down randomly. Evincing no memory of their past, they take what is commonly called a random walk, each step of which is independent of past steps. There is over time, however, an upward trend, as if the coin being flipped were slightly biased. There is a story Ive always liked that is relevant to the impossibility of anticipating new developments. It concerns a college student who completed a speed-reading course. He noted this fact in a letter to his mother. His mother responded with a long, chatty letter of her own in the middle of which she wrote, Now that youve taken that speed-reading course, youve probably finished reading this letter by now. Likewise, true scientific breakthroughs or applications, by definition, cannot be foreseen. It would be preposterous to have expected a newspaper headline in 1890 proclaiming Only 15 Years Until Relativity. It is similarly foolhardy, the efficient market theorist reiterates, to predict changes in a companys business environment. To the extent these predictions reflect a consensus of opinion, theyre already accounted for. To the extent that they dont, theyre tantamount to forecasting coin flips. Whatever your views on the subject, the arguments for an efficient market spelled out in Burton Malkiels A Random Walk Down Wall Street and elsewhere cant be grossly wrong. After all, most mutual fund managers continue to generate average gains less than those of, say, the Vanguard Index 500 fund. (This has always seemed to me a rather scandalous fact.) There is other evidence for a fairly efficient market as well. There are few opportunities for risk-free money-making or arbitrage, prices seem to adjust rapidly in response to news, and the autocorrelation of the stock prices from day to day, week to week, month to month, and year to year is small (albeit not zero). That is, if the market has done well (or poorly) over a given time period in the past, there is no strong tendency for it to do well (or poorly) during the next time period. Nevertheless, in the last few years I have qualified my view of the Efficient Market Hypothesis and random-walk theory. One reason is the accounting scandals involving Enron, Adelphia, Global Crossing, Qwest, Tyco, WorldCom, Andersen, and many others from corporate Americas Hall of Infamy, which make it hard to believe that available information about a stock always quickly becomes common knowledge. Pennies and the Perception of Pattern The Wall Street journal has famously conducted a regular series of stock-picking contests between a rotating collection of stock analysts, whose selections are a result of their own studies, and dart-throwers, whose selections are determined randomly. Over many six-month trials, the pros selections have performed marginally better than the darts selections, but not overwhelmingly so, and there is some feeling that the pros picks may influence others to buy the same stocks and hence drive up their price. Mutual funds, although less volatile than individual stocks, also display a disregard for analysts pronouncements, often showing up in the top quarter of funds one year and in the bottom quarter the next. Whether or not you believe in efficient markets and the random movement of stock prices, the huge element of chance present in the market cannot be denied. For this reason an examination of random behavior sheds light on many market phenomena. (So does study of a standard tome on probability such as that by Sheldon Ross.) Sources for such random behavior are penny stocks or, more accessible and more random, stocks of pennies, so lets imagine flipping a penny repeatedly and keeping track of the sequence of heads and tails. Well assume the coin and the flip are fair (although, if we wish, the penny can be altered slightly to reflect the small upward bias of the market over time). One odd and little-known fact about such a series of coin f l ips concerns the proportion of time that the number of heads exceeds the number of tails. Its seldom close to 50 percent! To illustrate, imagine two contestants, Henry and Tommy, who bet that heads and tails respectively will be the outcome of a daily coin flip, a ritual that goes on for years. (Lets not ask why.) Henry is ahead on any given day if up to that day there have been more heads than tails, and Tommy is ahead if up to that day there have been more tails. The coin is fair, so theyre equally likely to be in the lead, but one of them will probably be in the lead during most of their rather stultifying contest. Stated numerically, the claim is that if there have been 1,000 coin flips, then its considerably more probable that Henry (or Tommy) has been ahead more than, say, 96 percent of the time than that either one has been ahead between 48 percent and 52 percent of the time. People find this result hard to believe. Many subscribe to the gamblers fallacy and believe that the coins deviations from a SO-SO split between heads and tails are governed by a probabilistic rubber band: the greater the deviation, the greater the equalizing push toward an even split. But even if Henry were way ahead, with 525 heads to Tommys 475 tails, his lead would be as likely to grow as to shrink. Likewise, a stock thats fallen on a truly random trajectory is as likely to fall further as it is to rise. The rarity with which the lead switches sides in no way contradicts the fact that the proportion of heads approaches 1/2 as the number of flips increases. Nor does it contradict the phenomenon of regression to the mean. If Henry and Tommy were to start over and flip their penny another 1,000 times, its quite likely that the number of heads would be smaller than 525. |
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