Unwitting believers in the Efficient Market and Random Walk
Jason Hsu
believers in the Efficient Market Hypothesis and the Random Walk when it
comes to the issue of asset allocation. Everyone says to keep a
constant percentage of assets in stocks, bonds, and cash, and this
allocation should depend ONLY on one's personal financial situation and
to NEVER change this allocation because of anything that happens in the
market. Such advice seems to rest on the assumption that markets NEVER
overlook anything and are ALWAYS random and that the risk and profit
potential of any security remains constant over time.
On the other hand, I find the Efficient Market Hypothesis and
Random Walk concepts preposterous. If these were true, then the DJIA at
381 in 1929, 1050 in 1973, and 2722 in 1987 had no more risk and just as
much profit potential as the DJIA at 41 in 1932, 570 in 1974, and 770 in
1982. Both concepts fly in the face of the fact that stocks are units
into which company ownership is divided and that stocks frequently sell
at prices at which negotiated transactions could never take place.
There have been cases of stocks selling for less than the cash owned by
the underlying company (thus giving the buyer most or all of the
business for free) or at huge multiples of the entire company's
revenues. Such things could not possibly happen in a negotiated
transaction. The Efficient Market Hypothesis and Random Walk also fly
in the face of such investment greats as Warren Buffett, Peter Lynch,
John Templeton, and Benjamin Graham, who consistently outperformed the
market by buying stocks of companies they believed were selling for much
less than true business value even as run-of-the-mill money managers
simply took the PR way out by following what everyone else does.
I believe that one should only buy stocks one believes are
selling for much less than their intrinsic business value. I believe
that if one has difficulty finding such stocks, it means the market is
overvalued and dangerous and cutting back or eliminating one's stock
exposure would be prudent. And I believe that if the market is brimming
over with such undervalued stocks, most or all of a person's assets
belong in the stock market.
Questions? Comments? Criticisms? Funny Stories?
Bob Hiebert CDS
> On the other hand, I find the Efficient Market Hypothesis and
>Random Walk concepts preposterous.
I agree......kinda. I believe the efficient market works very similar
to demographics. Marketeers can leverage off of demographics to target
products. There is probably no single person in the world that looks
like that target customer, but the model is an accurate representation
that will maximize sales.
The stock market prices reflect a distorted weighted average of the
beliefs of everyone interested in that stock. There are probably very
few people that believe the current price is perfect. The desire to buy
or sell diminishes the further away the price is from an individuals
target (though we all buy at a higher price and sell at a lower price
then we *really* want). This creates a weighted average effect of
individual opinions based on desired price vs. knowledge of the company
vs. amount of cash willing to invest.
Part of where I believe there are weaknesses in the theory is that there
are people with great knowledge, who don't participate in the market
because the price is just too far out of line. While they can
participate in derivatives, their trading is too small for the rest of
the market to react.
The discussions here about Storage Technology comes to mind. Even with
all of the technical people here on Usenet, I would be willing to bet
there are less than 50 that *really* understand the marketplace,
business prospects, or even potential applications for large disk arrays
and such. The knowledge is available to the public, but we don't understand
or know what to do with it.
This prevents my believing in the Efficient Market as an absolute
value. I believe it to be probablistic with some form of spectral
density and variance. Wish I knew how to calculate it, but then I would
be affecting my own experiment.
Just my opinions. Sorry this grew so long.
Bob Hiebert
--
Not speaking for Tektronix | "Heresies are experiments in man's
| unsatisfied search for truth."
| - H.G. Wells
Duane Jacobson
: It has been my observation that most people are unwitting
: comes to the issue of asset allocation. Everyone says to keep a
: constant percentage of assets in stocks, bonds, and cash, and this
: allocation should depend ONLY on one's personal financial situation and
: to NEVER change this allocation because of anything that happens in the
: market. Such advice seems to rest on the assumption that markets NEVER
: overlook anything and are ALWAYS random and that the risk and profit
: potential of any security remains constant over time.
I agree that index funds and the notion of efficient markets has gotten a
little too hyped up. The S&P500 kicked butt during much of the 80's and
1990, and Index500 funds caught on. Of course, any fully-invested fund
with low expenses will do well in a roaring bull market. However, throw in
some tough years and the story changes.
: I believe that one should only buy stocks one believes are
: selling for much less than their intrinsic business value. I believe
: that if one has difficulty finding such stocks, it means the market is
: overvalued and dangerous and cutting back or eliminating one's stock
: exposure would be prudent. And I believe that if the market is brimming
: over with such undervalued stocks, most or all of a person's assets
: belong in the stock market.
: Questions? Comments? Criticisms? Funny Stories?
I like the value approach to investing. Going back to the early 70's,
value stocks have returned more money (with less volatility) than growth
stocks. Sounds like a win-win situation to me. Of course, the victor in
the growth vs. value contest depends on the particular time period chosen,
but the differences are not very large over 10+ year periods of time and
value stocks give a much more consistent return.
The last edition of Graham's "The Intelligent Investor" was written just
before the disasterous years of '73 and '74. Even though stocks looked
expensive at the time (and apparently they were), Graham found it difficult
to argue for less than a 50% committment to stocks. Why? He saw stocks
similarly overvalued in earlier years, only to have the market post smart
gains. Nobody is really very good at predicting the market (Warren Buffett
being the possible exception!!).
FYI- The Browne's of Tweedy-Browne will be on "Your Portfolio" this Friday
(7pm EDT, CNBC). They are diehard value investors, and have recently
started two mutual funds. It should be interesting.
Oren Haber-Schaim
>in the face of such investment greats as Warren Buffett, Peter Lynch,
>John Templeton, and Benjamin Graham
It is not really a binary question, but the _degree_ to which
these concepts hold, and the above "greats" are not necessarily
very far apart on that. You might agree with those hypotheses
more than you think.
Regarding Benjamin Graham, a little shocker:
P. 183 Malkiel, quoting Benjamin Graham in Financial Analysts Journal
shortly before he died in 1976
"...I am no longer an advocate of elaborate techniques of security
analysis....", "...This was a rewardng activity, say, 40 years ago..."
"...I'm on the side of the 'efficient market' school of thought".
du...@parrothead.nrlssc.navy.mil
[.....]
|> On the other hand, I find the Efficient Market Hypothesis and
|> Random Walk concepts preposterous. If these were true, then the DJIA at
|> 381 in 1929, 1050 in 1973, and 2722 in 1987 had no more risk and just as
|> much profit potential as the DJIA at 41 in 1932, 570 in 1974, and 770 in
|> 1982.
To paraphase "Cool Hand Luke". What we have here is a failure to understand
probablity and changing market fundementals. The past is always easy to predict.
The key here is that AT THOSE TIMES the market was fairly valued. Take the
Dow at 41 in 1932. At that time it was unclear if capitalism itself would
survive so why be a fool and own capital. Plus there were many better things
to do with your money then like by up assets from the newly broke at fire sale
prices than risk it on the market. So with perfect hindsight you can find
better things to do with the money than play the market.
|> Both concepts fly in the face of the fact that stocks are units
|> into which company ownership is divided and that stocks frequently sell
|> at prices at which negotiated transactions could never take place.
|> There have been cases of stocks selling for less than the cash owned by
|> the underlying company (thus giving the buyer most or all of the
|> business for free) or at huge multiples of the entire company's
|> revenues.
These two examples are explained by overhanging liabilities(greater cash than
stock value) and growth (hugh multiples).
|> Such things could not possibly happen in a negotiated
|> transaction.
So no company has EVER paid a high multiple of expected revenue for another
company. Can you say Viacom?
|> The Efficient Market Hypothesis and Random Walk also fly
|> in the face of such investment greats as Warren Buffett, Peter Lynch,
|> John Templeton, and Benjamin Graham, who consistently outperformed the
|> market
Here is another point at which you attempt to predict the future by a murky
understanding of the past. 1) Warren Buffett tends to buy control of companies
and the changes the company fundementals. I classify him as a management great
not as an investment great. 2) I'm not so sure about Peter Lynch's recent
performance. Now he makes his money selling books and guessing the future, not
betting on that future. In other words I think that his performance is regressing
toward the mean. 3) Tell me how you could have predicted thier performance
BEFORE it happened. In efficent markets some people WILL out perform the market
but you have to ask yourself if it is statisticly important number. I rarely
meet a gambler who does not think luck caused his loosing days and skill
caused his winning days. When you have a game (investment) that is tilted
toward winning (averge positive return on investment) there are bound to be
more people who are crowing about there skill than whinning about luck.
In the end the stats don't lie. Buy hold and forget pays the best in the
long run. (No transaction costs gives you a higher return.) Now this doesn't
stop me from playing instead of boring old hold because I love the game
and the gamble.
John Dubberley
Naval Research Lab
du...@parrothead.nrlssc.navy.mil
Jason Hsu
>
> The last edition of Graham's "The Intelligent Investor" was written
just
> before the disasterous years of '73 and '74. Even though stocks
looked
> expensive at the time (and apparently they were), Graham found it
difficult
> to argue for less than a 50% committment to stocks. Why? He saw
stocks
> similarly overvalued in earlier years, only to have the market post
smart
> gains. Nobody is really very good at predicting the market (Warren
Moral of the story: Do NOT expect persistent overvaluation to
continue.
Jason Hsu
> In article <2vemo4$7...@vixen.cso.uiuc.edu>,
jh...@eng-nxt04.cso.uiuc.edu (Jason Hsu) writes:
>
> [.....]
> |> On the other hand, I find the Efficient Market Hypothesis and
> |> Random Walk concepts preposterous. If these were true, then the
DJIA at
> |> 381 in 1929, 1050 in 1973, and 2722 in 1987 had no more risk and
just as
> |> much profit potential as the DJIA at 41 in 1932, 570 in 1974, and
770 in
> |> 1982.
>
> To paraphase "Cool Hand Luke". What we have here is a failure to
understand
> probablity and changing market fundementals. The past is always easy
to predict.
> The key here is that AT THOSE TIMES the market was fairly valued. Take
the
> Dow at 41 in 1932. At that time it was unclear if capitalism itself
would
> survive so why be a fool and own capital. Plus there were many better
things
> to do with your money then like by up assets from the newly broke at
fire sale
> prices than risk it on the market. So with perfect hindsight you can
But a third of all stocks (hundreds) were selling for less then
the working capital, compared with 1/40 (dozens) in 1982 (according to
_Forbes_) and perhaps about two or so today.
>
> These two examples are explained by overhanging liabilities(greater
cash than
> stock value) and growth (hugh multiples).
>
But the company (unless it is Wang or Midway) is worth much more
than its net liquidity. And huge multiples often discount more growth
than can realistically be expected. Remember the Nifty Fifty?
>
> So no company has EVER paid a high multiple of expected revenue for
another
> company. Can you say Viacom?
>
I didn't follow this story.
>
> In the end the stats don't lie. Buy hold and forget pays the best in
the
> long run. (No transaction costs gives you a higher return.) Now this
doesn't
> stop me from playing instead of boring old hold because I love the
game
> and the gamble.
>
If the Efficient Market and Random Walk were true, how could the
Nifty Fifty have been bid into the ionosphere? Couldn't anyone have
seen that in order for Avon to justify its multiple, tens of billions of
people would have had to spend all of their income on its products? And
in 1932, couldn't anyone have picked out one (out of the hundreds of
stocks selling for less than working capital) cash-rich, high growth,
high profit margin company with a franchise and make out like a bandit?
Of course, to bet against conventional wisdom would have required heavy
insulation from the manic-depressive lemmings who dominate the markets.
John Dubberley
present. Efficient market theory does not say the prices reflect absolutely
the future value of the company. Just that prices reflect the average best
guess at the companies price AT THAT TIME. If the price seems too low to most
investor money, the price will rise. If the price seems too high, it will fall.
Not much to it. You continualy think that just because you see
a trend with 20/20 hindsight you could have easily seen it at that time.
This is the second greatest misunderstanding of probability ( after the
famous "3 heads in a row the next MUST be tails" falicy). With hindsight you
can find hundreds of thousands of examples of good bets and bad bets after the
fact but that does nothing to refute the effecient market theory.
Here is a simple example. By Hsu's reasoning it is obvious that betting on
the Knicks to win the last basketball championship was a terrible bet and
should have had long odds. Yet the Knicks were favored in Vegas. Why?
Because AT THAT TIME it seemed that the Knicks were a better team.
Where there are holes in the efficient market theory is in the area
that knowlege does not travel instantaniously through the market so there are
possible abitrage wins to be made. However no individual investor has a ghost
of a chance catching these and these oportunities tend to evaporate with
time. As time has increased the inefficientcy has decreased to the point that
it is now way less than transaction costs or management fees that must be
paid.
John Dubberley
Naval Research Laboratory
du...@parrothead.nrlssc.navy.mil
NCS/TRE 931 2407277)
> time. As time has increased the inefficientcy has decreased to the point that
> it is now way less than transaction costs or management fees that must be
> paid.
Isn't always an open question, how to measure efficiency of the
markets?
How do you know that the market (in)efficiency has changed?
I think that you should express cumulative market inefficiency
relative to time. I checked one liquid stock and in 70% of
days its high-low range exceeded normal stock transaction
costs. Seems to imply intra day market inefficiency.
With derivatives (they have lower transaction costs per stock)
daily volatility exceeding transaction costs would occur
in 90% of days.
Tarmo
JIM O'REILLY
philosphy is just common sense. Great buying opportunities come along about
once every ten or twenty years. Then one can buy the stock for less than the
cash in the register.
But you need to have money then--and nerve because it seems at those times
that the end of everthing is nigh. Tremendous gloom an d doom. They say that
in a depression money returns to its rightful owners. Do you think a big
buying opportunity is in th
e cards soon?
John Dodson
Interesting comments. BTW, I'm currently reading a book called "A Random Walk
Down WallStreet" (or something close to that) by Malkiel. Your comments sound
an AWFUL lot like this book. Coincidence?
My view is that the "efficient" markets are reactionary, not proactive. Hence
they're efficient in the sense of "zeroing" in on the price a stock should be
trading for. I view it as a slow mechanical arm that overcompensates both ways,
but has a sort of dampening effect (zeroing in with each overcompensation).
Just my views,
John
--
John Dodson
Austin, Texas NOTE - The views expressed here are soley mine
internet: j...@austin.ibm.com and are independent of my employer's.
JIM O'REILLY
astute investor capitalizes on them. Then the market is efficient until the
nextmore knowledgeable or less knowledgeable investor does his thing.
Edmund Unneland
>This prevents my believing in the Efficient Market as an absolute
>value. I believe it to be probablistic with some form of spectral
>density and variance. Wish I knew how to calculate it, but then I would
>be affecting my own experiment.
statistical analysis is that a statistical relationship is not the same as
one in physics. I adhere to the "wimpy" form of market efficiency: the market
as a whole and over time tends toward efficiency. Just because the market
tends toward efficiency doesn't mean that there will not be bubbles and
panics. Perhaps as chaos theory becomes better developed there will be better
explanations for these phenomena.
Edmund Unneland
>In the end the stats don't lie. Buy hold and forget pays the best in the
>long run. (No transaction costs gives you a higher return.) Now this doesn't
>stop me from playing instead of boring old hold because I love the game
> and the gamble.
to do it again. It never works for longer than 2-3 months. Glad to know I'm
not alone.
mark.m...@ccmail.adp.wisc.edu
Bzzt. You're saying "the market prices things efficiently, only it takes awhile for it
to arrive at the proper value." Then by definition, while this transition is going on
(but not yet completed) the market is inefficient, because it's not yet properly
valued.
Of course the market EVENTUALLY arrives at the quote-unquote "real" value of a
commodity, if only for a second, as it does its bid-ask dance. Ohterwise EVERYTHING
would be irrational, wouldn't it?
I don't know where this thread started (I haven't been reading the group as closely
lately, there seems to be more smoke than fire in general), but I would say that, if you
believe in the so-called "efficient market," your "density and variance" are really
measures of uncertainty and changing expectation (at market, sector, and security
level -- there, that's 6 variables for you at least!). Future expectations, and the
certainty of those expectaions, will of course affect perceived value.
Having said all that ... I would say that I agree w/ your POV, only I wouldn't try to
call myself an "efficient market" subscriber. I believe that emotions easily get out of
control with some, and too many people are looking at what other people are doing
instead of thinking for themselves, and tend to follow the herd (towards either extreme).
The boat eventually settles again, yes, but the over-reactions that tip it are anything
but efficient. But I've never done a study, of course - this is anecdotal. I definitely am
quite "inefficient" myself :-) but patience usually makes up for that ...
Mark
Micheal J. Ott
There is no edict from God that markets must be and are efficient
and therefore that's the end of our obligation to think.
Obviously, if you think about, there needs to be
some players in the market that render it efficient.
This means that before such players "do their thing",
that there is some so-called inefficiency.
The point is, and Louis Rukeyser please take note, that just
because folks are able to make profits in the market
does not mean that the markets are inefficient,
and does not invalidate/disprove the eff. markets hypothesis.
(OK, is it a theory or a hypothesis? who cares. it says what it says.)
It is because of the efforts of these players that markets are efficient to the rest of us (more or less efficient, here more, I would submit.)
If you do not beleive that, try your luck at investing on
the advice of the bozos on the street,
or on some ill-thought out or naive strategy.
Do this 20 or 30 times.
Then you will have a first-rate education on the EMH.
>>It is obvious that inefficiencies come into the market from time to time. The
>>astute investor capitalizes on them. Then the market is efficient until the
>>nextmore knowledgeable or less knowledgeable investor does his thing.
BTW, I am flaming the title of Jim O'reilly's post
more so than his actual text...