Arnold Kling  

Resisting Efficient Markets

Comment of the Week, 2003-06-1... Drug Price Discrimination?...

Columnist James Glassman discusses the Efficient Markets Hypothesis with John Allen Paolos, author of A Mathematician Plays the Stock Market.

If you believe in the EMH, you understand that highly successful stock selections are really just lucky guesses...

But, to tell the truth, while I believe in the EMH intellectually, I have a hard time acting on it.

I have read Paolos' book, and one its themes is how, in spite of his understanding of the efficient markets hypothesis, he invested heavily in Worldcom and rode the stock most of the way down.

As Paolos and Glassman point out, there are observations in behavioral economics that suggest that people invest irrationally, which would tend to undermine market efficiency. Unfortunately, one of the biggest components of irrationality is to over-estimate one's own skill at investing.

For Discussion. If the majority of people who believe that they are superior investors are in fact inferior investors, what should you do if you believe that you are a superior investor?

COMMENTS (14 to date)
Eric Krieg writes:

I was thinking about this issue when I was enjoying a day at the track yesterday. Being father's day, it was packed with inexperienced bettors (me included, I was just there so my 2 year old son could see the horses).

Being para-mutual, you are betting against your fellow bettors, not against the house. So you would think that an experienced bettor would have a significant advantage, with all the newbies taking the high odds and picking horses based on names and colors.

So much for that theory. My wife picked a horse based on its name, and it won. There's a certain randomness to any system that cannot be entirely overcome by experience.

rvman writes:

Put all of your money in index funds. For five years, pick stocks and invest with monopoly money, matching your real original investment in your fake portfolio. If you can beat the market for those five years, and at least 4 of the 5 individual years, consider playing the game for real. (Make sure your "timeframe" includes both an upturn and a downturn.)

If you are not willing to invest the time and energy to do something like this, leave your money in the funds - you have neither the energy nor the long-run approach necessary to succeed in individual investing. (Most people don't.)

dsquared writes:

>>Being para-mutual, you are betting against your fellow bettors, not against the house. So you would think that an experienced bettor would have a significant advantage, with all the newbies taking the high odds and picking horses based on names and colors.

Actually, considerable amounts of statistical evidence demonstrate that in pari-mutuel betting, an experienced bettor adopting a strategy based on short-odds bets and careful pool selection can generate a positive expected return. Burton Fabricand's book "The Science of Winning" presents the evidence on this one, and despite the fact that this particular book also contains a stock market system that I regard as flaky, the racetrack results have been reproduced elsewhere.

In related news, Arnold's discussion question seems to me to be subtly fallacious. If 90% of people who go on a diet fail to lose weight, what should you do if you believe that you are overweight?

Eric Krieg writes:

You would think that horse racing would be a vibrant subject for computer modeling. Like the stock market (and baseball!), there is a wealth of data on which to base a model.

Eric Krieg writes:

Google rules.

dsquared writes:

>>You would think that horse racing would be a vibrant subject for computer modeling. Like the stock market (and baseball!), there is a wealth of data on which to base a model.

Unfortunately, less in the way of regulation to prevent you from being taken to the cleaners by a corner or betting coup, which is why it attracts less liquidity, which in turn keeps the real money away.

Bernard Yomtov writes:

I don't think the fact that people invest irrationally undermines EMH.

You would have to show that the irrationality lets you construct portfolios that earn abnormal profits.

Jim Glass writes:

>>The paradox, he told me in an interview last week, is that, if all investors were convinced that markets were efficient, they would simply sit on their holdings, never buying or selling. In such a world, new information about stocks would never enter the market, moving the prices of stocks in an efficient way.

"The EMH is true," he said, "to the extent that people believe it to be false and so, by their exertions, bring about efficiency." Cool.

Eric Krieg writes:

More Glassman, same subject:

Bruce Bartlett writes:

Re the comment that those who can beat the S&P for 5 years with monopoly money should consider managing money for a living. Just don't forget to deduct the relevant transactions costs and taxes. A principal benefit of index funds is that they have very low transactions costs and normally generate little in the way of taxes until you sell the shares. Also, anyone planning this experiment must have enough money invested to achieve sufficient diversity in their portfolio. Otherwise, it is just a crap-shoot. For most small investors, the ability to diversify is a primary advantage of index funds.

Brian G.W. Lim writes:

I don't think the (5 year) simulated portfolio idea works. Fake portfolios don't evoke the same emotions as real ones. Any conclusion about ability that you would derive would be unfounded. That's why I don't do fake portfolios in private or in games (even when there are incentives such as to win an luxury automobile, as I recall.)

Brian G.W. Lim writes:

If you believe you are a superior investor you should manage your investments. You will keep the expenses that otherwise would have been paid to somebody else -- even a low expense index fund or ETF. The compounding on this will amount to a lot of money.

If you believe you are superior but are not, all the better for the rest of us.

Bernard Yomtov writes:

I don't think you can mange your own investments at anything close to the cost of an index fund. Looking at a Vanguard S&P 500 fund prospectus, for example, I find that their expense ratio is .18%. So if you have $100,000 in the fund you pay $180 a year for management. You can't beat that price yourself, and you won't beat the returns either, on a risk-adjusted basis.

Gregory writes:

In the context of the individual investor the ideals of EMH are indeed a disconnect between the regulators of information (Financial Institutions) and the classifications of its investors.

The crux of your agenda deals with the diseminations of financial data. If this data were allocated as EMH dictates then investment decisions would be more lucid & truthful and reflected in portfolio performance among investors. Yet since the lack of fluid information exists or even more importantly its analysis thus there are dis-equilibriums in stock prices, such as those of Worldcom, Enron, Adelphia, etc. These are rather more extreme examples but 1 fact is clearly evident from the divergence of their underlying value at the time of their downfall and their reflected stock price...key-insider information was restricted by a select few who profited and violated the Strong-Form EMH.

It is this very symbiotic & synergistic relationship between the financial institutions and corporations that causes these disconnects between investors & EMH. There are varied forms of information restricion & witholding in this fashion, some grave & grandeur while others deal just with minute details. While 75% of market activity is institutional it would only seem logical that for these institutions to withhold any damaging information that would upset there revunues and to collude with corporate management to profit in a win-win situation at the expense of the marginal investor.

So to answer your agenda, unless you are Corporate Management, Wall St Executive or have powerful insider-information contacts you will be limited in your success in investing in securuites. Granted others factors influence success as well, education, data, tools, analysis, and discipline. These 5 traits of successful investing can explain in my opinon the limitations of EMH for the marginal investor, as it only applies to the financial instituitions whom regulate this information be it legal or not.

Superior investors may think that they are so because they possess sophisticated software & utilize complicated mathematical anaylses, yet they lack discipline, education, or proper interpretation and vice versa. If you believe that your are a superior investor then: define your philosophy, explain your methodology, understand the logic of your analysis, and site factual precedents that you base your conclusion upon. And last but not least be able to clearly explain to a marginal investor your strategy & have a comparitive benchmark with a proven track record of performance or at least proven factual conclusions. If this cannot be defined then according to my opinion one is not a superior investor.

FEAR & GREED, the 2 constructs that clearly diminish rational decision processess in the context of investing. Once profits & opportunities become excessive certain chemical changes occur in the reaction of the brain (of which I cannot explain) that disregard logical & disciplined thought, then emotions take over which cause a chain-reaction to over come any rational / common-sense wisdom, thus compunding the problem. The difference between superior & inferior investor declines towards irrationality and a belief in excessive expectations fed to them by the financial institutions, both insiders & outsiders alike.

Gregory G. (3rd-Year Finance Major @ RIT)

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