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On The Efficient Markets Hypothesis, Or, How Cats Are The New Monkeys With Dart Boards…

January 19th, 2013 · 6 Comments
Buyer Beware · Finance · Markets

One of the most fundamental concepts in finance is the efficient markets hypothesis. In case you are unfamiliar with the concept, here’s a bit of background:

The efficient markets hypothesis has historically been one of the main cornerstones of academic finance research. Proposed by the University of Chicago’s Eugene Fama in the 1960′s, the general concept of the efficient markets hypothesis is that financial markets are “informationally efficient”- in other words, that asset prices in financial markets reflect all relevant information about an asset. One implication of this hypothesis is that, since there is no persistent mispricing of assets, it is virtually impossible to consistently predict asset prices in order to “beat the market”- i.e. generate returns that are higher than the overall market on average without incurring more risk than the market.

You can see more about the efficient markets hypothesis (the EMH to those of us in the know) here. One important implication of the efficient markets hypothesis is that, if financial markets are in fact efficient, finance professionals wouldn’t be able to consistently (or an average) achieve higher returns in the stock market than, as is often said, a monkey with a dart board covered in ticker symbols. (This reference technically comes from Burton Malkiel’s A Random Walk Down Wall Street, in which he postulated that “a blindfolded monkey throwing darts at a newspaper’s financial pages could select a portfolio that would do just as well as one carefully selected by experts.”)

In general, there seems to be a decent amount of support for this implication, as, for example, it is often reported that actively managed mutual funds don’t outperform index funds enough in general to make their higher fees worth it, and, in an given year, roughly half of mutual fund managers manage to beat the market (as would half of dart-throwing monkeys, on average). In other words, Warren Buffett is very much the exception rather than the rule:

Yup, that’s Berkshire Hathaway.

As one who likes both data and animal humor, I am of course curious as to what, if any, controlled experiments have been conducted with mutual fund managers and dart-throwing monkeys. (Keith Chen, I’m counting on you on the monkey front.) In addition, I would like to know whether the findings of said experiments would generalize to other species and/or modes of stock picking. I mean, would Gizmo with a Ouija board be a match for a guy at Fidelity?

On the monkey front, the closest approximation is probably the Wall Street Journal’s long-running but sadly discontinued dartboard contest. In this sample (N=100), the professionals beat the “monkeys” 61 percent of the time, but they beat the Dow almost exactly half of the time. (This would suggest on some level that the “monkeys” were systematically poor dart throwers.) My beef with this study is that the “monkeys” were WSJ staffers and not actual monkeys (the publication claims that this was for liability reasons, which is, unfortunately, probably a wise decision).

Luckily, there are other people out there who are at least as sick and twisted as I am, so we can bring Orlando the stick-picking cat into the conversation. Orlando, ingeniously enough, picks stocks from a set of 5 companies listed on the FTSE All-Share Index by throwing his toy mouse onto a grid of numbers that map to the companies. In this manner, Orlando competed against both investment professionals and school children in a year-long competition run by the Observer, where participants were allowed to change their picks every quarter. So how did Orlando do?

By the end of September the professionals had generated £497 of profit compared with £292 managed by Orlando. But an unexpected turnaround in the final quarter has resulted in the cat’s portfolio increasing by an average of 4.2% to end the year at £5,542.60, compared with the professionals’ £5,176.60.

Wow, that’s gotta sting a little…but at least the professionals managed to beat the school children, who ended up losing money on their portfolio over the course of the year. (Corollary: Don’t let the E*Trade baby handle your investments.)

It seems like the evidence on beating the market is pretty firmly entrenched in the “you can’t” region…and even Warren Buffett acknowledges that the best plan for an individual investor is to go with a passive index fund. This is good though, right? At the very least, economists (and assorted animal enthusiasts) have gone to the trouble of amassing data that should help people avoid having false beliefs and expectations regarding financial markets, and this should help people make better investment decisions.

Well, not so fast- in order for the knowledge to have an impact, people have to actually believe it. On this point, I refer you back to a document that I talked about last week. From Paola Sapienza and Luigi Zingales:

Or perhaps this:

The public actually grew more confident in its ability to pick stocks successfully after learning that economists think it is close to impossible.

Seriously people? I get that there could be some sort of cognitive dissonance that won’t allow people psychologically to acknowledge that they can’t outwit a cat in all cases, but I can’t help but be offended that economists seem to have been placed in a category of wisdom below that of Orlando the stock-picking cat. I would be okay with this if there were some way to profit off of the public’s lack of respect, but that would require that people systematically underperform the market, which is also mostly ruled out by the efficient markets hypothesis. (This is somewhat akin to the notion that it’s almost as hard to get every question wrong on the SAT as it is to get every question right.) Although, come to think of it, I could just take a “well, if you believe that, I have a bridge to sell you” approach and start a investment company where I hire Orlando as a fund manager. (It’d at least keep my labor costs down, since Fancy Feast and catnip are cheaper than Porterhouse steaks and cocaine.) Are there SEC rules against this???

If you, like me, are an economist who is somewhat depressed by the cat comparisons, this will probably make you feel both better and worse:

All I know is that right after I hire Orlando as my fund manager I will be hiring this guy to run my trading desk.

Tags: Buyer Beware · Finance · Markets

6 responses so far ↓

  • 1 Faisal // Apr 22, 2013 at 7:15 am

    The problem with these studies done by economists is that they actually don’t know much about finance. In the random walk down wall street, the author is defining Analyst or Mutual Fund managers as ‘professionals’. Analysts don’t have much money on the line and hence, everyone knows their incentives aren’t aligned. Mutual Fund managers don’t ‘invest’, their incentive is to just grow their assets as much as possible. The proper criteria to judge the EMH is to look at Hedge Funds. Funds like Berkshire Hathaway, Renaissance, Bridgewater Associates, Baupost Capital etc etc have been beating the market for many many years. Yes it hard and requires one to be very smart but it is not impossible. Then, there is the Momentum Effect which has not been addressed by EMH proponents. Finally, if one doesn’t believe the market can be beaten with a lot of work, read the Big Short by Michael Lewis where he porfiles investors who saw the financial crisis coming (which goes against Fama’s view that people only know it is a crisis/recession AFTER it has happened).

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