I enjoyed this article, but I disagree with the conclusion that “it would be just as well for them to put their money in an index fund.” The problem is that the average investor — who has a job, a family, a social life, hobbies, house chores, etc. — has no time to devlop “superior abilities” at stock-picking and no rational way of choosing which fund manager will be one of the managers who has “superior abilities” (or luck) and outperforms the market average. It has long been proven that a manager’s past performance has zero correlation with his future performance. Since there’s no way to know which manager will exhibit “superior abilities” (or get lucky), the only rational choice is to invest in an index fund. So it wouldn’t be “just as well” to invest in index funds, as the author says. Rather, investing in index funds is the only rational choice.

Janensch, your theory sounds like this to me:
Assume a person has no time to keep track of the market on their own. Assume the only way a person can pick fund managers is by their past returns. This method doesn’t work – Therefore, investing in an index is the only rational choice.

However, a person does have some time to devote to investing – and if they are right in the trends they chose they will do well. Were market indices in early 2000 pricing in Austrian Business Cycle Theory? They can easily pick fund managers (or their own stocks) which have the same asymmetrical information the person has. Saying that indices are the only rational choice is making assumptions which are as bogus as many of those in EMH.

Selling stocks short isn’t necessarily fraud. The fraud exists only so much as the people who purchase stocks held in the brokerage house’s name for them don’t know that their stock is being lent out to be sold short and would disagree with that lending. The more people are informed about the situation, the less it is fraud. If someone finds our about it and doesn’t like it they can register the stock to their names and the problem is solved.
The same argument can be made for deposit funds. If people realized and agreed that their deposits weren’t actually deposits but were conditional deposits then a lot of the fraud in fractional reserve banking would disappear.

Index funds also aren’t the ‘only rational investment’ when entering a secular bear market.

Which is probably now. Considering stock prices after the prior 2 decades of secular bull conditions, the probability of a painful/prolonged credit contraction, plus the net debtor position and the absence of savings for capital formation in most markets… the prospects of any prolonged rise in stock indices for the next decade or two are grim.

In fact, dumping money into stocks, whether via mutual funds or the indices, is likely a singularly bad idea at this point in the cycle. I bet the only way a stock price index can possibly show positive change over the next twenty-odd years is through a decline in currency value (netting zero or negative return, therefore, when adjusting for inflation).

So as far as my estimation of opportunity costs go, I’m avoiding paper assets. Don’t quite have the stomach or heart to play along with the greater fools.

Duodecimal raises a good point about Bear markets. In fact, conventional finance theory (e.g. Random Walk) does not recognize that markets do in fact trend at times. Admittedly, trends may or may not persist, but some of the great trend followers achieve extraordinary returns over long periods of time by taking advantage of this tendency of markets to trend.

Karlsson is correct in suggesting that some managers will be able to beat the market.

The Efficient Market Hypothesis says that market prices are fair: they fully reflect all available information. This does not mean that prices are perfect; some prices may be too high and some too low, but there is no reliable way to tell. In an efficient market, investors cannot expect to earn above-average profits without assuming above-average risks. Market efficiency does not suggest that investors can’t “win.” Over any period of time, some investors will beat the market, but over longer periods the number of investors who do so will likely be no greater than expected by chance.

You can find a number of useful academic articles regarding EMT at this link.

http://library.dfaus.com/articles/

Back to the fraud comments and short selling. In the US, every investor with a margin account signs an agreement allowing their shares to be loaned to the short seller. Only shares from margin accounts are loaned to short sellers. No fraud, it is a mutually agreed upon contract. The investor is granted a line of credit and the firm obtains use of the shares for the short seller.

It may be that some people can beat the market. But look at it this way. The returns from identifying a mispricing are proportional to the capital you can bet. Someone with ten million to use on a mispriced stock can make 100 times as much as someone with a hundred grand to bet.

This means the guy with ten million can afford to spend a hundred times as much money finding that mispricing. Therefore the chance of an individual small investor being able to outperform the market is zero. He would have to find a mispricing that smart, experienced professionals using fast computers with big budgets missed.

Big hedge funds do better than index funds. But I am very skeptical that an individual can do the same.

For anyone who even considers EMH or gives Random Walk theory the time of day I have three words for you….

ELLIOTT WAVE THEORY

Regards
JJ

From the article:

“But even apart from that there is another related fundamental problem with EMH, namely that it rests on the absurd assumptions of the “Perfect Competion” model of markets, both in terms of assumptions about people´s knowledge and the impact of their trading on the market.”

I disagree here. While the market may not have perfect information, it is going to be difficult to get more information than all the other professional traders. I think that many investors do act rationally based in new information on a particular firm.

Steven, I didn’t say anything about who will have the best knowledge, only that knowledge is imperfect. And of course it seems likely that usually big investors will have better knowledge then smaller investors because the former has more resources to gain information.

However as a matter of fact, the big mutual funds more often than not underperform and trail stock indexes such as the S & P 500 . This is probably partially due to the fact that their size prevents them from investing in stocks with low volume , but it might also indicate that the analysis methods they use are bad.

“What I cannot understand is why there are so many investors out there who believe that other investors have “mis-read” the information on a particular firm, or that the other investors simply haven’t taken the time to absorb the information that is available. Hence, the myth of the “undervalued” stock is born.”

I actually explained several reasons why undervaluations (and overvaluations) will inevitably occur. The fundamental value of a asset (including a stock)is of course the present value of all future cash flows going to the owner of that asset. But because the size of that future cash flow is unknown the fundamental value is also unknown. There are however of course clues which enables investors to assess roughly what is more or less likely to happen with future profits. What clues will give the best prediction of future profit differs very much from company to company and this is likely to make the guesses of all those cloned MBA-types at mutual funds to go very wrong in some cases.

And there is various issues controlling both supply and demand for stocks which are more or less unrelated to stocks. Including waves of optimism and pessimism, bank credit expansion and
changes in time preference and risk aversion. And since most people do not intend to hold stocks forever, such factors must also be considered in their investment decisions.

For anyone who has followed the markets in recent years and experienced things like NASDAQ 5000, the idea that stocks or other assets are never under- or overvalued seems very implausible to put it mildly.

“We do not usually go around in our daily lives searching for items that are for sale that we believe are “undervalued.”"

Well, sure, at least if you mean “undervalued” in the sense of something which can be bought and sold (We do however look for bargains when it comes to consumer goods and so on) . But that is because such investment decisions is the jobs of professional entrepreneurs.

“We know a priori and from experience that markets for any good or service have adequate information to set accurate equilibrium prices.”

Actually equilibrium prices means that prices will be at the level which equalizes supply and demand, not that the future investment return will be equal for all investment objects.

Mr. Karlsson:

Assuming that what you say is true, that undervaluations do occur, we must now question the degree that they do occur, and how long they last. On the one hand under the “perfect informataion” doctrine we have a “perfectly tight” market, one that has no undervaluations. On the other hand we have an “extremely loose” market, in which undervaluations occur with signifcant frequency. Obviously the stock market is somewhere in between.

If the stock market was extremely loose, we would witness arbitrary prices in which firms that had a large amount of assets, excellent track records and great profit potential i.e. robust firms, could very well be on the pink sheets for weeks before the stock price corrected. Vice versa for firms about to go bankrupt.

To say that the market cannot be efficient if it is not “perfectly tight” is misleading. I agree that the market is not “perfectly tight,” but on the other hand we know that it is not “extremely loose” either.

It is my contention, however, that the stock market is tight enough to the degree that speculation in it is relatively unprofitable, and I think you tend to admit this in the last part of your article.

Also from your article:

“The advocates of EMH are like people who say that there can never be any bills or coins to be found on the street because if there had been any money on the street someone would have picked it up. Yet if someone has picked up the money then these people would have been contradicted since the people who have picked up the money would have done what the other people said was impossible. Thus, the assumptions underlying the conclusion that there can be no money on the street or no profit opportunities in financial markets are in itself in direct contradiction with the conclusions they are supposed to prove!”

I do not believe that people who believe in the EMH say that there is never any money in the street, just that there isn’t money in the street often enough for us to quit our day jobs and search for it all day long. Afterall, Mr. Karlsson, when was the last time you picked up a large bill off the ground?

Andy:

It seems to depend on what point in the credit cycle. During the NASDAQ run-up, there were a number of articles (pre-2000) in the news detailing the exploits of a monkey picking stocks and beating some famed managers.

I expect that during a period of credit deflation, such random pickings are less likely to beat conscious choices.

So I guess that if the general trend is up, and things are imbalanced by monetary/credit inflation, expert managers would be nonplussed by the seemingly irrational behavoir of the stock market (i.e., Warren Buffet being derided by BH shareholders for not getting in on the dot-com boom).

Since the effects of inflation are unpredictable to any precise extent, random choices that ignore conventional wisdom could conceivably cast a net wide enough to catch the range of stocks that get reeled in by the mania.

The same goes for deflation, but with the opposite effects. I’m sure quite a few people would be amused by an actual empirical performance study including both sides of the boom/bust cycle even if it provides no actual predictive benefits for future cycles.

“What I wrote was that for the vast majority of people , speculation is not profitable. But for people who have some advantage (not necessarily permanent)in knowledge and/or method of analysis speculation will be profitable. And it is on that issue where my disagreement with EMH lies.”

In that case I would have to say that speculation in the the stock market is in fact very much like gambling. In your average casino the vast majority of gamblers don’t stand a chance against the house odds. You see, the vast majority of gamblers either play slot machines which are hopeless, or they play table games which are also unbeatable, or which require quite a bit of skill to beat.

Nontheless, there are a very select few gamblers who are experts. They know which games are beatable, and they know how to beat them. For instance, in Blackjack there are people who know how to count the cards and bet accordingly in order to beat the house. Also, for video poker there are people who know which machines to play and how to play every hand in order to get a positive expectation.

However, gambling is relatively unprofitable, often times even for experts. The reason why is that in order for gambling to be worth their time, they need a nice sized bankroll. Then, once they get this bankroll they can’t just plop it on the table in one shot, their risk of ruin would go through the roof. The laws of statistics dictate that when one has a positive expectation, it is best to play this out over as many events as possible. In fact, this is what the casino does by imposing table limits. The casino enjoys the luxury of having millions of small bets made relative to the very large house bankroll (millions of dollars for the big casinos). Therefore, when the expert gambler takes the role of the house by getting a positive expectation they have to break their bankroll up into small units and bet them over a long period of time, and slowly grind out their advantage. Even after doing all that, however, there is usually a small chance that they will go bust before doubling their initial investment.

I would venture to estimate that for the expert trader things are worse. The reason why is that an expert gambler can at least calculate their risk of ruin, and all the other probabilities they need. After that, the actual game becomes simply a mechanical process, ignoring for a moment the fact that they have to avoid detection by the house.

The expert trader, however, has no way of knowing their true advantage over the market. Furthermore, the expert trader does not have the luxury of being able to make a lot of small “bets.” If they do indeed have an advantage over the market, they are going to have to use this advantage over a much fewer number of events. The reason why is that every trade they make incurs a charge. Unlike the expert gambler, who can simply break up their bankroll, the expert trader is going to have to limit the number of investments they make, greatly increasing their risk of ruin.

Then there is the problem, as you pointed out of one’s advantage over the market not necessarily being permanent. This is in contrast to an expert gambler whose advantage in a particular game of Blackjack, while small, is indeed, a permanent one.

Therefore, the stock market may not be gambling, as the EMH proponents say, it is actually LESS desirable than gambling.

“No, you’re wrong. You’re assuming that the expert trader gains a positive expectation by taking extraordinary risks. Even EMH acknowledges that you can gain a positive expectation by taking large risks. What defines a expert trader is his ability to have higher return given a certain level of risk. If you have superior abilities or knowledge it is very easy to achieve high returns without taking large risks.”

That’s my point though. Compared to an expert Blackjack player the expert trader IS taking extraordinary risks. An expert Blackjack player with a “measly” positive expectation of around 1% can be virtually guaranteed to double his initial stake before going broke, given a thousand or two betting units.

Now let’s take a look at the expert trader. The expert trader would be lucky to get a 20% return in a year, let alone 100% and he is certainly not virtually guaranteed to not go broke before he doubles his initial investment.

“Your view that they risk being “ruined” is virtually impossible unless they take extremely high risks like betting all their money on options or being highly leveraged. But that is not what most superior traders do nor is that necessary for them to achieve high earnings.”

Whatever their risk of ruin is, it does exist, and it is a lot higher than the expert gambler’s. Furthermore, since the expert gambler can make precise calculations, he can control his risk of ruin. If he wants to double his bankroll faster but with more risk he decreases his betting units, vice versa if he wants to almost completely eliminate RoR. The expert trader on the other hand will never be able to completely control his RoR, because the stock market is dynamic and is affected by unprecedented events.

“Even superior traders make bad investments and suffer losses sometimes of course, but that only means losing a small part of their money, a loss which can be made up for in the next trade.”

Then there are days in which the entire market tanks, along with the “safe” investments they were relying on.

Don’t forget, Stefan: It is just as rare for stock markets to rise more than a few percent in a day.

In the long run (FYI – my ‘short term’ is five years, so that may give some idea of what a youngun like me considers to be a long run), no one would have made any real money by being invested in indexes. The ~10x gain over the last three or so decades in the DOW, for example, parallels the ~10x fall in the value of the dollar (relative to, for example, gold).

I’ve taken to viewing the stock market indexes of late as almost as much a proxy for inflation detection as precious metals.