Four Pillars of Investing - Efficient Market Theory!?!?

[Running_Man]

I just picked up the Four Pillars of Investing from the local library. For one I have never believed in the efficient market theory. Mr Bernstein does however and as prove shows how the top 10% of funds over a 5 year spread drastically underperform the market in following years. The fact that one can easily identify funds that will underperform the market by a large margin with statistical certainty DISPROVES the idea that the market is random. The proving of either side disproves the point he is using in favor of indexing.

This also seems to miss the point indexing and it's growing popularity in the Vanguard nation has never been tested in a prolong downturn as in the 1966-1982 market or the 1930's. In the 30's the equivalent of mutual funds were investment trusts which for the most part all went belly up. It is conceivable with a large following of index investors a panic of selling will actually hurt indexers far worse than individuals holding stocks not in an index. Such as perhaps DSX...
Every organized collective of financial genius where the public does not have to think for themselves and instead can trust the collective genius of financial gurus has lead to the discrediting of that form of investing.

I have seen this book reccomended along with the Intelligent Investor and the 2 could not be more different.

Any business can be priced, otherwise there would be no purchases of companies by other companies. Knowing what to pay for a company was well illustrated in another thread earlier today on these boards. The idea that it can't be done is so well accepted as to make it's practice all the more profitable in the long run.

[samclem]

Originally Posted by Running_Man

Mr Bernstein does however and as prove shows how the top 10% of funds over a 5 year spread drastically underperform the market in following years. The fact that one can easily identify funds that will underperform the market by a large margin with statistical certainty DISPROVES the idea that the market is random. The proving of either side disproves the point he is using in favor of indexing.

If you believe it is possible to "easily identify funds that will underperform the market by a wide margin" then you know how to easily make a rapid fortune from this--just short those securities. Shhh-don't tell anyone about this!!

EMT does not include any notion that the market is "random." It posits that all things that can be known about a security (to include expectations of the comapny's future earnings, etc) are already included in the price of that stock.

I don't follow your point about index-based investing and crashes. Do you believe that investors who have their money in index funds are more likely to sell at the sign of a downturn than investors who have money in managed funds or individual stocks?

I agree that Bernstein and Graham provide different aproaches that investors can use to be successful in the market. I believe in a small value premium (which takes me out of the strict EMT camp). If you want to be actively involved with picking stocks, please do that! You might make a lot of money. All those folks who continue to buy/sell stocks based on their research/beliefs/hopes/opinions is what keeps them priced fairly, and the whole idea of indexing depends on that. If everybody indexed, it wouldn't work anymore.

[chinaco]

I believe that some people can and do beat the martket over a long period. Warren Buffet/Berkhatty is proof of that. Obviously the trick is picking companies that on average rise more than the market (i.e., respective index).

I can be done by individual investors if you:

1) educate yourself properly and use proven strategies
2) are self disciplined enough to watch over your holdings and stick with your plan (don't let fear or greed take over)
3) have time to research and have access to the right information.


One advantage the small investor has over the large investor is that they will not move the market with Buys and Sells.


The key thing that makes the market unfair is insider information. And you better believe that this abuse occurs. All of the time.


As far as picking something like a microsoft or intel early on and getting a 12000% increase in 10 years... That is luck! Companies like that could have just as easily slipped into oblivion... and many like it did!

That said, I pick Microsoft after it was on everybody's radar screen and still made alot of money from it... Intel also.


The strategy that I like best for trading (not daytrading) is the IBD approach (CANSLIM).

But I tend to be a buy and hold guy.


After the tech wreck, I decided to just index it. I sold all individual stocks (except employer shares that we must keep) and got rid of most actively managed funds. I am content with the indexing approach.

Oh sure... I am like everyone else, I want to make a killing. But I am not willing to invest the time to properly research companies. Even after purchasing the information from a service like S&P, value line, etc... It still takes alot of time.

[Running_Man]

[al_bundy]

I think the market is efficient over the period of a year or so, not in the short term. Back in 1998 the nasdaq was 40% down from it's peak and then rocketed back to finish the year on a positive note. nothing efficient about that.

picking MS and Intel isn't luck. you want to find the next one do a screen for companies that grow their earnings 20% or more a year, grow the top line at the same levels, high levels of management ownership, 15% or higher return on equity, < 5 billion market cap. you will probably find the next one there.

[Olav23]

There are also 3 forms of the efficient market hypothesis, snagged from wikipedia:

Weak, Semi-Strong, and Strong form.

In a weak-form efficient market current share prices are the best, unbiased, estimate of the value of the security. Theoretical in nature, weak form efficiency advocates assert that fundamental analysis can be used to identify stocks that are undervalued and overvalued. Therefore, keen investors looking for profitable companies can earn profits by researching financial statements.

Semi-Strong:

Share prices adjust within an arbitrarily small but finite amount of time and in an unbiased fashion to publicly available new information, so that no excess returns can be earned by trading on that information.

Semi-strong form efficiency implies that Fundamental analysis techniques will not be able to reliably produce excess returns.

Strong:

Share prices reflect all information and no one can earn excess returns.

To test for strong form efficiency, a market needs to exist where investors cannot consistently earn excess returns over a long period of time. Even if some money managers are consistently observed to beat the market, no refutation even of strong-form efficiency follows: with tens of thousands of fund managers worldwide, even a normal distribution of returns (as efficiency predicts) should be expected to produce a few dozen "star" performers.

http://en.wikipedia.org/wiki/Efficie...orm_efficiency

Malkiel's "Random Walk Down Wall Street" delves into all of these, and it a pretty good read in general.

[d]

It is conceivable with a large following of index investors a panic of selling will actually hurt indexers far worse than individuals holding stocks not in an index. Such as perhaps DSX...
Every organized collective of financial genius where the public does not have to think for themselves and instead can trust the collective genius of financial gurus has lead to the discrediting of that form of investing.

what we foolish index investors need is an index of non-indexed stocks!

[. . . Yrs to Go]

Originally Posted by chinaco

I believe that some people can and do beat the martket over a long period. Warren Buffet/Berkhatty is proof of that. Obviously the trick is picking companies that on average rise more than the market (i.e., respective index).

I can be done by individual investors if you:

1) educate yourself properly and use proven strategies
2) are self disciplined enough to watch over your holdings and stick with your plan (don't let fear or greed take over)
3) have time to research and have access to the right information.

That Warren Buffet has produced excess returns does not, in and of itself, prove markets are inefficient. An efficient market will produce a normal distribution of returns, with some active investors earning above average and some below average returns. Over time active investors cumulative returns will converge around the mean (less transaction costs), but the return distribution will still have positive and negative tails. That is to say that some lucky folks will earn excess returns and some unlucky folks will earn below average returns. But that has nothing to do with investment skills, its just the law of probabilities. Similarly, if ~32,000 people were to flip a coin 15 times, someone in the group should flip 15 straight heads or tails . . . that doesn't make them a better coin flipper then anyone else. It also doesn't provide any useful information about the outcome of the next coin toss. Naturally people will look at the guy who flipped 15 straight heads (or beat the market for 15 straight years) and conclude that the next toss is more likely to be heads then tails, but its not.

And individual investors are at such an enormous disadvantage that it is virtually impossible for them to generate above average risk adjusted returns. It's not even worth the time, in my view. The idea that someone can spend a couple hours a week studying the entire market and find value where teams of folks working 80+ hours on small slices of the market, with access to management and with access to institutional money flow information, can not is beyond belief.

Originally Posted by al_bundy

picking MS and Intel isn't luck. you want to find the next one do a screen for companies that grow their earnings 20% or more a year, grow the top line at the same levels, high levels of management ownership, 15% or higher return on equity, < 5 billion market cap. you will probably find the next one there.

Perhaps. But you will also find scores of very expensive growth stocks who's past turns out to be better than their future. If beating the market were this simple, managed funds wouldn't consistently trail their benchmarks.

[runchman]

People always throw out the Warren Buffet example.

Just now it occurs to me that Michael Jordan was to basketball what Warren Buffet is to investing.

How many of us think we can duplicate Michael Jordon's basketball performance ??

- John

[samclem]

Buffet is also a poor example because he (and the rest of the B-H team) actively get involved with many of the companies they own. They are more than investors, they actively add value to the company and the stock. This is not something an individual investor can do.

[Mysto]

My problem with the Buffet example is that in the Monte Carlo casino black came up 31 times in a row on a roulette wheel. Based on that data, I now know that I can go to the local casino and should bet on black.

If you feel that you can pick the winners - go to it... maybe you will. But the majority of data is on the side of the indexers.

[. . . Yrs to Go]

Originally Posted by Running_Man

Any business can be priced, otherwise there would be no purchases of companies by other companies. Knowing what to pay for a company was well illustrated in another thread earlier today on these boards. The idea that it can't be done is so well accepted as to make it's practice all the more profitable in the long run.

But there are scores of pension funds, mutual funds, hedge funds, etc. doing this kind of analysis and buying or selling stocks as a result. Today's stock price reflects the collective valuation opinion of all of these active money managers. I'm not sure why you think any individual, or even most institutions, will be able to come to a more accurate assessment of a stock's "fair value."

[Ed_The_Gypsy]

Warren Buffet is not your average investor. He has big muscles and uses them. He can get bargains where we can't. He is also not infallible, but even so has a great record. I have no prayer of duplicating his success.

EMT is a good model and is a good way to learn humility. I suppose that slice-and-dice and value investing are trying to take advantage of patterns of deviation from an efficient market. However, even as I slice-and-dice, I use index funds.

Obviously, half of those who think they can beat the market (or markets), can't. Using indexes, I can be sure that I will do better than half of all investors. If I use indexes to try to capture whatever premium there may be in value, at least I won't do worse than the indexes.

Like Unclemick, sometimes I try something else with a little play money. Still got those cojones, ya know. Judging from my successes, am not going to quit my day job and go day-trading.

[Olav23]

Originally Posted by Ed_The_Gypsy

EMT is a good model and is a good way to learn humility. I suppose that slice-and-dice and value investing are trying to take advantage of patterns of deviation from an efficient market. However, even as I slice-and-dice, I use index funds.

Fama and French revisit their initial conclusions in an interesting interview here:

http://www.investmentintelligencer.c...nd_french.html

Fama and French now disagree about the cause of the "value effect"--the phenomenon in which value stocks have outperformed growth stocks over the long term. French no longer believes that this outperformance represents "distress risk" and, instead, thinks there is some "mispricing" involved (investors underestimating the prospects for value stocks and overestimating them for growth stocks). Fama, ever the efficient market man, begs to differ.

Journal of Indexes (JoI): The market has been through some wild rides since you wrote your seminal paper in 1992. Has anything altered the views you have vis-à-vis the sources of return in the market?

Kenneth French (French): I don’t think so…

Eugene Fama (Fama): No, I don’t think so.

French: Actually, I take that back. Initially, we thought the value premium was associated with distress risk. I’m not so confident of that any longer.
What’s clear is that the value effect is a catch-all for differences in expected return. Without pernicious assumptions about expected growth, any differences in expected return will show up in ratios like book-to-market, earnings-to- price,
or cash flow-to-price. Take a company with a high expected return. When you discount its expected future cash flows back to the present, the high expected return (which is also the discount rate) gives you a low price relative to the
expected cash flows. As long as the fundamental metric—the book value, earnings, etc.—is a reasonable proxy for the expected cash flows, you’ll also get a low price relative to the current fundamental. This simple discount rate effect
implies that differences in expected return are almost certainly linked to ratios like book-to-market.
Notice that I didn’t say why there are differences in expected return; I just said that if there are differences in expected returns, they will show up in ratios like book-tomarket. That means the value effect is a catch-all that captures any
differences in expected return—whatever their source.
I think the differences in expected return are the result of an amalgamation of different risks, plus some mis-pricing.
And I don’t think we have the technology to distinguish between those two.

Fama: I don’t know about the mispricing. I don’t know that there is mispricing.

French: There has to be some mispricing. I’m certainly not saying it’s all mispricing. I like to tell people that it’s 87.38
percent risk.

Fama: I don’t know about the mispricing part. I think he’s wrong there.

French: To get back to distressed companies … the typical high book-to-market company is distressed. But if you hold book-to-market fixed and you sort companies by financial distress, you don’t get much difference in average returns.
So something else is at work.

[bssc]

Originally Posted by Ed_The_Gypsy

Warren Buffet is not your average investor. He has big muscles and uses them. He can get bargains where we can't. He is also not infallible, but even so has a great record. I have no prayer of duplicating his success.

I think that Warren Buffet's take that Mr. Market is manic-depressant is very true, why else would people pay all that money for those dot.com stocks. On the other hand, oil companies were in the doldrums a few years ago since gas was under $1 a gallon and would never change. I think that this is why value investing works. In the long run, the market may be efficient but in the long run, we will all be dead.

[ats5g]

My favorite thing about Buffet is that he repeatedly recommends individual investors use index funds.

- Alec

[maddythebeagle]

Originally Posted by ats5g

My favorite thing about Buffet is that he repeatedly recommends individual investors use index funds.

- Alec

True but not necessarily arguing for the same reasons that Bernstein presents....Buffet doesnt believe in EMT....to the contrary, he has written pretty vehemently against it...

[windsurf]

My favorite thing about Buffet is that he repeatedly recommends individual investors use index funds.

- Alec
My favorite thing about Warren Buffet is that I can (and do) buy his company's stock!