NW-Bound
Give me a museum and I'll fill it. (Picasso) Give me a forum ...
- Joined
- Jul 3, 2008
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- 35,712
And by the way, whether the market is efficient or not, it is the arguments that its proponents use that I have problems with.
Let's take two typical ones.
1) They say that by pure random chance, one will always have an investor that beats the market every year for 10 or 20 years in a row, similarly to "finding" a coin tosser that can land "head up" 10 or 20 times in a row. In case you are not familiar with this argument, here's how it goes.
Let's assemble several thousand people, say 2000 and ask them to toss a coin. If the coin is fair, roughly 1/2 or 1000 persons will toss "head up". Keep these and eliminate the other 1/2. Toss again, and we will eliminate another 1/2 and are down to 500 persons who toss 2 heads in a row. Keep on going and eventually we will get the person(s) who could go 10 heads in a row. And if we have a big enough sample size, we can find that person with the "ability" to toss 20 heads in a row. This proves that there's always that guy who is called skillful simply due to random chances.
So, where's the problem? It is that investment performance measurement cannot be based on annual binary comparison like the above!
Suppose we have an investor whose performance is paired with the market as shown below.
2) They say that the market has to be efficient because any inefficiency would be quickly observed and arbitraged out due to so many players in the market. That is actually a circular argument, the same as saying the market is efficient because it is efficient.
But it is still wrong in other ways, because it assumes that life is so simple. Let me apply the same argument in the following analogy.
Let's take two typical ones.
1) They say that by pure random chance, one will always have an investor that beats the market every year for 10 or 20 years in a row, similarly to "finding" a coin tosser that can land "head up" 10 or 20 times in a row. In case you are not familiar with this argument, here's how it goes.
Let's assemble several thousand people, say 2000 and ask them to toss a coin. If the coin is fair, roughly 1/2 or 1000 persons will toss "head up". Keep these and eliminate the other 1/2. Toss again, and we will eliminate another 1/2 and are down to 500 persons who toss 2 heads in a row. Keep on going and eventually we will get the person(s) who could go 10 heads in a row. And if we have a big enough sample size, we can find that person with the "ability" to toss 20 heads in a row. This proves that there's always that guy who is called skillful simply due to random chances.
So, where's the problem? It is that investment performance measurement cannot be based on annual binary comparison like the above!
Suppose we have an investor whose performance is paired with the market as shown below.
Year 1 - Market 20%, Investor 15%
Year 2 - Market 15%, Investor 12%
Year 3 - Market -30%, Investor -15%
Using the argument above, they will say that the market "wins" because it leads the investor 2 out of 3 years. But let's look at the cumulative returns.Year 2 - Market 15%, Investor 12%
Year 3 - Market -30%, Investor -15%
Market: 1.20 x 1.15 x 0.70 = 0.966
Investor: 1.15 x 1.12 x 0.85 = 1.0948
At the end of Year 3, the investor's return is higher even though he trailed the market 2 out of 3 years. The number of annual wins, even consecutive ones, means nothing.Investor: 1.15 x 1.12 x 0.85 = 1.0948
2) They say that the market has to be efficient because any inefficiency would be quickly observed and arbitraged out due to so many players in the market. That is actually a circular argument, the same as saying the market is efficient because it is efficient.
But it is still wrong in other ways, because it assumes that life is so simple. Let me apply the same argument in the following analogy.
"There cannot be bad politicians, because the democracy process is fair and cannot elect a bad one. Furthermore, if a bad politician were somehow elected, he/she would not last long as we have a recall process to remove him/her from power. Conclusion: Our politicians have to be perfect."
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