A Mathematician Explains the Paradox of The Efficient Market Hypothesis

I came across this article this morning. I had stuck it in the pages of Paulos's book "A Mathematician Plays The Stock Market"
It is a good short summary of the "efficient market hypothesis"

WALL STREET JOURNAL, SEPTEMBER 2, 2003 OpEdAll Investors Are LiarsBy JOHN ALLEN PAULOS

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As an author of a recently published book, I've noticed an odd inefficiency in the book market. Online booksellers often charge different amounts for the same book even though a couple of clicks worth of comparison shopping can reveal the disparity. This seems to violate the Efficient Market Hypothesis, which, applied to the stock market, maintains that at any given time a stock's price reflects all relevant information about the stock and hence is the same on every exchange. Despite its centrality and its exceptions, it's not widely appreciated that the hypothesis is a rather paradoxical one.First, let me note that the hypothesis comes in various strengths, depending on what information is assumed to be reflected in the stock price. The weakest form maintains that all information about past market prices is already reflected in the stock price. A consequence of this is that all of the rules and charts of technical analysis are useless. A stronger version maintains that all publicly available information about a company is already reflected in its stock price. A consequence of this version is that the earnings, interest and other elements of fundamental analysis are useless. The strongest version maintains that all information of all sorts is already reflected in the stock price. A consequence of this is that even inside information is useless.
It was probably this last version of the hypothesis that prompted the old joke about the two efficient market theorists walking down the street: They spot a $100 bill on the sidewalk and pass it by, reasoning that if it were real, it would have been picked up already. An even more ludicrous version lay behind the recent idea of a futures market in terrorism.

Adherents of all versions of the hypothesis tend to believe in passive investments such as broad-gauged index funds, which attempt to track a given market index such as the S&P 500. Opportunities, so the story continues, to make an excess profit by utilizing arcane rules or analyses, are at best evanescent since, even if some strategy seems to work for a bit, other investors will quickly jump in and arbitrage away the advantage. Once again, it's not that subscribers to technical charting, fundamental analysis or tea-leaf approaches won't make money; they generally will. They just won't make more than, say, the S&P 500.  (emphasis is mine)

So to what degree is the hypothesis true? The answer is surprising. The hypothesis, it turns out, has a rather anomalous logical status reminiscent of Epimenides the Cretan, who exclaimed, "All Cretans are liars." More specifically, the Efficient Market Hypothesis is true to the extent that a sufficient number (sometimes relatively small) of investors believe it to be false.
Why is this? If investors believe the hypothesis to be false, they will employ all sorts of strategies to take advantage of suspected opportunities. They will sniff out and pounce upon any tidbit of information even remotely relevant to a company's stock price, quickly driving it up or down. The result: By their exertions these investors will ensure that the market rapidly responds to the new information and becomes efficient.
On the other hand, if investors believe the market to be efficient, they won't bother. They will leave their assets in the same stocks or funds for long periods of times. The result: By their inaction these investors will help bring about a less responsive, less efficient market.
Thus we have an answer to the question of the market's efficiency. Since it's likely that most investors believe the market to be inefficient, it is, in fact, largely efficient. However, its degree of efficiency varies with the stock, the market and investors' beliefs.
The paradox of the Efficient Market Hypothesis is that its truth derives from enough people disbelieving it. How's that for a contrarian Cretan conclusion?
Mr. Paulos, a professor of mathematics at Temple University, is the author, most recently, of "A Mathematician Plays the Stock Market" (Basic Books, 2003).

Ideas That Have Shaped Our Lives

Sylvia Nasar, the author of "A Beautiful Mind" has written a history of the men, women and ideas that have shaped our economic world. 

I enjoyed this book for both its biographical profiles as well as its articulation of the economic ideas that have shaped the last 150 + years and still dominate our world today.

After reading this book, one may watch the talking heads on cable news, and observes the occupy Wall St protesters, and know that capitalism has struggled with very similar debates in the past. 

In the book one is remnded that prior to the 1850's the idea that the poor could be helped, that the economy could be "engineered", was an unthought of concept. Furthermore, we learn that capitalism has lifted many humans out of poverty and in the paraphrased words of Joseph Schumpeter: capitalism creates an economy where its not just the queen who can wear stockings, but also the working girl.  

Today we live in a richer world thanks to many of the ideas that Nasar explores. Lets hope that our current leaders and thinkers solve todays problems and continue to refine the system and not throw the baby out with the bath water.

Below is a fun little summary of the book:


http://www.youtube.com/watch?v=Io7Yuol8kd8

The Asylum, The Renegades Who Hijacked the World's Oil Market

The Asylum is the story of how the defunct Maine potato market morphed into the worlds oil market - the place that sets world oil prices. It is the history of how this came about and the men and women who play the game in a very dog eat dog culture.

I remember several years ago watching Fox's Bill O'Reilly yelling at oil industry representative John D'Agostino. O'Reilly was maintaining that there is  surely a secret organization that sets the price of oil. My thought then was that O'Reilly reads too many Ludlum novels. D'Agostino tried to educate Bill on energy markets and how prices are determined, but of course Bill knew better. This exchange is part of the prologue to Leah McGrath Goodman's book on the New York Mercantile Exchange (Nymex),  which then moves on to more completely explain what D'Agostino could not.

If you are at all curious about how the price of oil is determined and the personalities that inhabit this world, then this is a read that will educate and entertain you. Goodman has been reporting on the industry for years and knows her material.

Michael Angelucci has been certified as a CFP®, Certified Financial Planner™

Lockport, NY 10/31/2011- Michael C. Angelucci, CFP®, (President) of Angelucci Wealth Management, LLC in Lockport, NY has been authorized by the Certified Financial Planner Board of Standards (CFP Board) to use the certification marks CFP®, Certified Financial Planner™ and CFP (with flame design)® in accordance with CFP Board certification and renewal requirements. Mr. Angelucci specializes in retirement planning and investment management.

These marks identify those individuals who have met the rigorous experience and ethical requirements of the CFP Board, have successfully completed financial planning coursework and have passed the CFP® Certification Examination covering the following areas: the financial planning process, risk management, investments, tax planning and management, retirement and employee benefits, and estate planning. CFP® certificants also agree to meet ongoing continuing education requirements and to uphold CFP Board’s Code of Ethics and Professional Responsibility, Rules of Conduct and Financial Planning Practice Standards.

CFP Board is a nonprofit certification organization with a mission to benefit the public by granting the CFP® certification and upholding it as the recognized standard of excellence for personal financial planning. CFP Board owns the certification marks CFP®, Certified Financial Planner™ and federally registered CFP (with flame design) in the U.S., which it awards to individuals who successfully complete initial and ongoing certification requirements. CFP Board currently authorizes more than 61,000 individuals to use these marks in the United States. For more about CFP Board, visit www.CFP.net<http://www.CFP.net>.

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Wisdom from: "The Myth of the Rational Market"

Investing wisdom from: The Myth of the Rational Market: A History of Risk, Reward, and Delusion on Wall Street by Justin Fox. This book is a history of the developments in academia and on Wall St that lead to the belief that market prices are accurate predictors of asset prices (stocks, bonds, real estate, oil, gold etc.).
History has shown that the financial models that depended on this premise failed badly.

But,  most investors,  (those investing in their 401K plans) have very little chance of deviating away from the idea that stock and bond prices are efficient - that the average investor has little chance of predicting stock/bond prices.  At the end of the book Fox writes:

"First, its hard to beat the market. If you have money to invest, the only sensible place to start is with the assumption that the market is smarter than you. You don't have to stop there. But if you do come up with an idea for beating the market, you need a model that explains why everybody else isn't already doing the same thing you are. ....
If you're picking somebody else to manage your money, the chances of finding a market-beating path are even harder. You're now paying a fee that cuts into your performance. Since retiring as CEO of Vanguard, Jack Bogle has published a series of studies on the determinants of mutual fund performance. The only measure that seems to have any predictive value is the management fee funds charge. The higher the fee the worse the subsequent performance. Cost is thus a good, all-purpose, starting point in picking a money manager - one likely, but not certain to lead one toward index funds. There are surely some high-cost money managers who more than earn their fees. Maybe you can find one. But you can't just do it on the basis of performance - you need to have some cogent explanation of why a particular manager can beat the market. Good Luck."

What the Heck is Going On?

What the heck is going on? Stocks are selling off. What is the market doing on sell off days?  A couple things are happening:.

1. Lets say that based on information known to you a few days ago, you owned an investment called the stock market and because of the risk in the market you demanded an 8% return. Therefore, if you owned $100 worth of the stock market you expect to earn $8/year from that stock market investment. This $8 is made up of profits in the form of dividends and growth in the price of the stock market.
Then information on the economy is reported. The new information says the economic future is not as bright as yesterday. That may mean that the expected profits of stocks will be less than expected, so the $8 you thought you may receive is now expected to be only $7.  If you want to sell your $100 worth of stock on the bad day, nobody will pay you $100 because the buyer wants an 8% return, and a $7 return on a $100 purchase is not an 8% return. In order to get that return, the buyer will only buy your stock for an amount less than $100, in fact they may only be willing to buy your stock for $87 ($7 earnings divided by $87 = 8% return).  Thus the market goes down on the bad news day.

2. The second thing that is happening, is people panic. They see the prices going down and they want to protect themselves so they start selling their investments and there may not be as many buyers as sellers on a bad day. Guess what happens then, the buyers demand a better deal from you and further drive down your price.

The crazy thing is that today or Monday or next month, nobody knows, the news could be good and this whole thing is reversed. The markets swing wildly over short periods because day to day buying and selling is based on the news of the day.

This is all bad if you need to sell your stock on the bad days or during bad periods.

But, over long periods of time we do know that news averages out and historically has been positive. That is why the market is higher today than it was 20+ years ago. Stocks have always been like a person with a yo-yo walking up a hill.

Its the2nd item above, the panic selling, that usually drives prices far below their actual future value. That is why buying during a sell off is generally positive over the long term. You are buying shares that are undervalued.

For those who are young and are buying stocks (mutual funds) on an weekly basis in your 401K then you are most likely buying when the market is low compared to where it will be when you retire. Because when the current bad news turns good then your investments will start paying more in the form of higher dividends and market growth.

Mutual Funds - Fees Matter. New Study from Vanguard

Although Vanguard promotes low cost mutual funds, their data is consistent with a 2011 Morningstar study and many other studies that have been done over the years. Bottom line: fees may be the best predictor of long term mutual fund performance. FYI:  1. alpha is the amount a mutual fund outperforms the market.          2. survivorship bias-some studies remove closed mutual funds

Probability of remaining in top-performing fund quartile: Holding periods of 1, 3, 5, and 10 years (1990 through 2010) Too often, investors view a fund's historical performance as the most accurate predictor of its future success. But Vanguard has found that more than any other quantifiable attribute that we examined, lower costs are associated with higher risk-adjusted returns. The figure below shows the probability that an actively managed mutual fund in the top-performing quartile would remain among the highest-alpha funds in subsequent 1-, 3-, 5-, and 10-year periods. The outcome was no better than would be expected from a random selection of funds and was sometimes worse. Notes: Each fund was evaluated relative to its customized benchmark using the Fama-French-Carhart expanded market model (Fama and French, Journal of Financial Economics 33:3-56, 1993; Carhart, Journal of Finance 52:57-82, 1997). Sources: Vanguard calculations, using data from Morningstar, Inc. Data exclude sector funds, real estate funds, and specialty funds such as bear-market funds. Outperformance of U.S. equity mutual funds by expense-ratio quartiles: 5, 10, 15, and 20 years ended December 31, 2010 Our research shows that a fund's expense ratio is a more powerful predictor of relative performance than other readily observable fund characteristics. On average, for every 1 percentage point increase in expenses, alpha declined by 0.78 percentage point. The second most powerful variable was portfolio turnover.1 For every 1 percentage point increase in portfolio turnover, alpha declined by 0.22 percentage point. In the figure below, actively managed funds that outperformed their relevant style indexes over the 5, 10, 15, and 20 years ended December 31, 2010, are grouped by cost quartile. Over the 20-year period, 49% of the funds in the lowest-cost quartile beat the benchmark while a mere 16% of funds in the highest-cost quartile did so. Similar patterns were apparent in shorter time periods. Since selecting active managers that consistently outperform their respective benchmarks is such a difficult task, focusing on low-cost index funds is a helpful and valuable quantitative measure. Notes: Data reflect percentage of U.S. equity mutual funds that outperformed their style benchmark for periods ended December 31, 2010. Data include only funds that survived the respective 5-, 10-, 15-, or 20-year periods. “U.S. equity mutual funds” refers to all funds, including those focused on a particular style or market capitalization such as large growth or small value. Sector funds, specialty funds such as bear-market funds, and real estate funds were excluded from the list. Sources: Vanguard calculations, using data from Morningstar, Inc., MSCI, and Standard & Poor’s. Style benchmarks represented by the following indexes: large blend—S&P 500 Index, 1/1/1990 through 11/30/2002, and MSCI US Prime Market 750 Index thereafter; large value—S&P 500 Value Index, 1/1/1990 through 11/30/2002, and MSCI US Prime Market 750 Index thereafter; large growth—S&P 500 Growth Index, 1/1/1990 through 11/30/2002, and MSCI US Prime Market Growth Index thereafter; mid blend—S&P MidCap 400 Index, 1/1/1990 through 11/30/2002, and MSCI US Mid Cap 450 Index thereafter; mid value—S&P MidCap 400 Value Index, 1/1/1990 through 11/30/2002, and MSCI US Mid Cap Value Index thereafter; mid growth—S&P MidCap 400 Growth Index, 1/1/1990 through 11/30/2002, and MSCI US Mid Cap Growth Index thereafter; small blend—S&P SmallCap 600 Index, 1/1/1990 through 11/30/2002, and MSCI US Small Cap 1750 Index thereafter; small value—S&P SmallCap 600 Value Index, 1/1/1990 through 11/30/2002, and MSCI US Small Cap Value Index thereafter; small growth—S&P SmallCap 600 Growth Index, 1/1/1990 through 11/30/2002, and MSCI US Small Cap Growth Index thereafter. Past performance is not a guarantee of future returns. The performance of an index is not an exact representation of any particular investment, as you cannot invest directly in an index. 1 Turnover is a measure of a fund's trading activity. For this analysis, turnover was based on the lesser of the value of a fund's purchases or sales divided by average total net assets, as reported by Morningstar for the period specified.