February 25, 2007

Rollin' with Random Walk Investing

If you've taken a finance class in the past 10 years or have any interest in investment theory, you'e probably learned or heard about the efficient markets hypothesis. The efficient markets hypothesis essentially says that prices of assets in financial markets reflect all known information about those assets and are thus "efficient" or properly priced. Burton Malkiel's A Random Walk Down Wall Street is perhaps one of the most accessible and readable (i.e. you get to skip all the math and formulas and get right to the conclusions) books about this theory. The following is a copy/paste of UCLA law professor Steven Bainbridge's Amazon review/summary of Malkiel's Random Walk:

Two basic theories are expounded here. First, modern portfolio theory (MPT), which elucidates the relationship between risk and diversification. Because investors are risk averse, they must be paid for bearing risk, which is done through a higher expected rate of return. As such, we speak of a risk premium: the difference in the rate of return paid on a risky investment and the rate of return on a risk-free investment. In the real world, we measure the risk premium associated with a particular investment by subtracting the short-term Treasury bill interest rate from the risky investment's rate of return. The risk premium, however, will only reflect certain risks. MPT differentiates between two types of risk: unsystematic and systematic. Unsystematic risk might be regarded as firm-specific risk: The risk that the CEO will have a heart attack; the risk that the firm's workers will go out on strike; the risk that the plant will burn down. These are all firm-specific risks. Systematic risk might be regarded as market risk: risks that affect all firms to one degree or another: changes in market interest rates; election results; recessions; and so forth. MPT acknowledges that risk and return are related: investors will demand a higher rate of return from riskier investments. In other words, a corporation issuing junk bonds must pay a higher rate of return than a company issuing investment grade bonds. Yet, portfolio theory claims that issuers of securities need not compensate investors for unsystematic risk. In other words, investors will not demand a risk premium to reflect firm-specific risks. Why? There is a mathematical proof, which relates to variance and standard deviation, but Malkiel explains it in a way that is quite intuitive. Investors can eliminate unsystematic risk by diversifying their portfolio. Diversification eliminates unsystematic risk, because things tend to come out in the wash. One firm's plant burns down, but another hit oil. Thus, even though the actual rate of return earned on a particular investment is likely to diverge from the expected return, the actual return on a well-diversified portfolio is less likely to diverge from the expected return. Bottom line? If you hold a nondiversified portfolio (say all Internet stocks), you are bearing risks for which the market will not compensate you. You may do well for a while, but it will eventually catch up to you (as it has recently for tech stocks).

The second pillar of Malkiel's analysis is the efficient capital markets theory (ECMH). The fundamental thesis of the ECMH is that, in an efficient market, current prices always and fully reflect all relevant information about the commodities being traded. In other words, in an efficient market, commodities are never overpriced or underpriced: the current price will be an accurate reflection of the market's consensus as to the commodity's value. Of course, there is no real world condition like this, but the securities markets are widely believed to be close to this ideal. There are three forms of ECMH, each of which has relevance for investors: **Weak form: All information concerning historical prices is fully reflected in the current price. Price changes in securities are serially independent or random. What do I mean by "random"? Suppose the company makes a major oil find. Do I mean that we can't predict whether the stock will go up or down? No: obviously stock prices generally go up on good news and down on bad news. What randomness means is that investors can not profit by using past prices to predict future prices. If the Weak Form of the hypothesis is true, technical analysis (a/k/a charting)-the attempt to predict future prices by looking at the past history of stock prices-can not be a profitable trading strategy over time. And, indeed, empirical studies have demonstrated that securities prices do move randomly and, moreover, have shown that charting is not a long-term profitable trading strategy. ** Semi-Strong Form: Current prices incorporate not only all historical information but also all current public information. As such, investors can not expect to profit from studying available information because the market will have already incorporated the information accurately into the price. As Malkiel demonstrates, this version of the ECMH also has been well established by empirical studies. Implication: if you spend time and effort studying stocks and companies, you are wasting your time. If you pay somebody to do it for you, you are wasting your money. ** Strong Form holds that prices incorporate all information, publicly available or not. This version must be (and is) false, or insider trading would be profitable.

In the last section of RANDOM WALK, Malkiel distills all this theory into an eminently practical life-cycle guide to investing. As one may infer, it has two basic principles. First, diversification. Second, no one systematically earns positive abnormal returns from trading in securities; in other words, over time nobody outperforms the market. Mutual funds may outperform the market in 1 year, but they may falter in another. Once adjustment is made for risks, every reputable empirical study finds that mutual funds generally don't outperform the market over time. Malkiel's recommendation: put your money into no-load passively managed index mutual funds. You will see lots of anonymous reviews of RANDOM WALK claiming Malkiel is wrong. Odds are, most of those folks are have either been misled by the long bull market or, even more likely, are brokers or other market professionals who make a living selling active portfolio management. In sum, buy it, read it, believe it, and practice it.
So, basically, if you believe in Malkiel's analyses as I do, all you technical analysis guys out there looking at double tops, head and shoulders, wedge formations and what not are kidding yourselves. And, so are you fundamental value guys figuring out which P/E's are low. But, what about the Warren Buffets and Peter Lynchs of the world who have proven track records of consistently beating the market? There's no doubt that there are a certain number (a small number, by the way) who have had amazing performances over time - is it a matter of skill and abilities or are these individuals outliers, the guys who are several standard deviations above the mean in the distribution of the universe of investors? With the number of people out there playing the markets, probability theory predicts a certain number of Warren Buffets will make it out of the fray.

So, why do I embrace the Random Walk school of thought? One, because I think the theory is right, and two, it's expedient for me to do so (I understand the latter is not much of a justification). For starters, as smart and talented as I like to think I am (Mrs. Honcho's protestations notwithstanding), there are lots of much smarter folks out there working in finance and trading in the markets who are unable to consistently beat the market. And because I have limited time and resources to devote to research, the chances of me being one of the Warren Buffet multi-standard deviation outliers is about none to none. Sure, there's probably some genius holed up in an apartment in the likes of Brooklyn who has figured out a computer program to calculate and find temporary arbitrage opportunities in the market and make profits from that, but overall it's hard to see how markets aren't efficient. Do you really think Jim Cramer or Money Magazine is providing you information that isn't already known or readily accessible?

So what do the Honchos generally invest in? Index funds (including large, mid and small cap equities as well as exposure in foreign markets - e.g, SPY, QQQ, IWM, EEM) and retirement age-based fund of funds (e.g., VTIVX, VFIFX). Not only can you get a diversified holding of stocks and bonds through these holdings, investing in index funds and fund of funds takes away a lot of the thinking involved in picking individual stocks. This isn't to say that Mr. Honcho doesn't delve in the occasional small-cap stock here and there. Irrational you say? Absolutely. More thoughts on this as well as the first part of Malkiel's analysis (modern portfolio theory) at a later date.

Labels: ,


Post a Comment

Subscribe to Post Comments [Atom]

<< Home

Subscribe to Post Comments [Atom]