Get Rich by Destroying Wealth

[_Analytics]

EMH will be the baseline for economists for a very long time, if not indefinitely....

Modern portfolio theory (including EMH) has a couple big things going for it. First, the models are quite elegant. Second, they provide answers which are usually pretty good. Given those two things, I don't expect it to be going anywhere.

But if you win, we both win. If stock price fluctuations are the results of wild mood swings of traders, and the world is converted to value investing, the mood swings will cease, no one will have an information advantage anymore, and the market will be efficient.

Greenblatt's theory is that wild mood swings are endemic to the market. If everybody became more rational, nulifying the advantage of his formula, it would be a big blow to his claims.

I did notice when I looked Greenblatt up that he is a professor. If his work finds a permanent home at a business school here and there, great. Austrian economics also has a foothold in at least two legitimate universities.

The Austrians have George Mason University and Mark Skousen. Value investors have Columbia University, Warren Buffett, and John Bogle. I don't think it's comparable.

But EMH is still the 800 pound gorrilla. It's spit at all over blogs on the internet by day traders, investors, policy advocates, apparently now the far right, and by anyone angry at the crash, and by at least one large index fund manager as you've explained. But nevertheless, it's still the textbook model. It's still core to the CFA exam. It's still the foundation of the Black-Scholes pricing model for options....

Rewording Packer's famous words, not everything that is useful is true.

EFM is useful, but it's a model built on assumptions that aren't always true.

Warren Buffett responds with two possible approaches: if you have the time, look for bargains--you'll find them. If you don’t have the time, buy an index fund.

Why not just invest in a value fund and let a professional arbitrager make more money for me per risk taken then I would investing in an index fund?

Because most professionals aren't very good at it, and they charge you a lot in fees.

[_Gadianton]

Because the stock price isn't a measure of the current value of the company. That number would be found by adding up all the assets of the company (including intangible assets), and subtracting the liabilities. His examples of using well-known companies isn't even that good. A better example would be look at bubbly IPO's, where the public value of the company goes from zero, to some speculative number, and then up or down from there.

The stock price is a reflection of the future value of a share in the company. Since no one can know the future, the stock price fluctuates as stock buyers and sellers adjust their best guesses. Sometimes their guesses are good, and sometimes they are terrible.

Granted, some might argue that the current stock price does reflect the value of the company in that someone could theoretically buy the company today by buying all the stock today, but in reality, the very act of trying to buy that much stock can have a dramatic influence on the price of the stock.

I like this answer. If I had to give a textbook answer, it would be similar to what I think you're saying, I'd say the stock price is the present value of future returns out to infinity. But I don't think the teacher would be happy with this answer, he wants to know what company fundamentals justify the stock price. As you point out, that's difficult.

I'd feel like he's trying to trap me into doing fundamental analysis, which is contrary to the gospel. All I could do I guess is rise and bear testimony before the class of rationality assumptions. I would tell him that the investors have the true model of the economy, and that price simply reflects the output of that model. If our metrics tell us a contrary story, then our metrics are wrong. All he could do in return is rise and bear testimony that people aren't rational. He might show me his portfolio, and show that he computes a statistically significant alpha regressing against the S&P 500 over a long term, but I would point out that the EMH rests upon a joint hypothesis that allows the CAPM to be false, yet EMH still true. He has not yet made a case for irrationality. I would argue that even if the market is not efficient, this does not require the assumption of investor irrationality. Economists from EMH apologist John Cochrane to Nobel-Prize critic Joseph Stiglitz, a Keynesian Obama supporter, maintain investor rationality, technically. Cochrane explains anomalies by risk preference, which is more of a revision to EHM than a debunking of it. Stiglitz made his career on assymetric information. This is key: When assymetric information is present, individuals are rational but the market outcome isn't. Irrationality as a formal assumption in real economics can be found in behavioral economics, which is relatively new ground. To the average person post-crash, it might seem that economists have been completely stupid, of course investors are irrational, this has to be the way to go. But the framework is extremely limited here, what does a model of an irrational world look like?

I found a quote that explains this problem better than I have been:

http://www.economist.com/node/14030296

(good article by the way for various perspectives on efficiency issues)

Mr Scholes, however, insists that the efficient-market paradigm is not dead: “To say something has failed you have to have something to replace it, and so far we don't have a new paradigm to replace efficient markets.” The trouble with behavioural economics, he adds, is that “it really hasn't shown in aggregate how it affects prices.”

Anyway, a trading scheme isn't an economics model and an economics model isn't a trading scheme, though each have implications for each other. If the value method is something we can expect to work in the long term, the economics behind the scene isn't as easy as saying EMH is dead and people are just irrational. There are further implications for an irrational world as well, if policy making is tough in a world where people are rational, I don't know how policy makers are going to fix irrationality.

[_Gadianton]

Because most professionals aren't very good at it, and they charge you a lot in fees.

To me, the world you paint is much like the exploding poker industry. Poker is a skill-based game but with a lot of uncertainty about the value of a hand and therefore, big rewards and losses that aren't always easy to match up to what is skill and what is luck. Casinos don't play it, they just take the rake. Casino's don't even have a significant interest in sending a shark in undercover to take spoils as all the "noise traders" add dimensions to the unpredictability of the game. But there are those few who somehow figure out the tricks, rise to the top, and seem to take the pots. So why is the poker scene so hotly fueled with new blood? It's all the "little books" and glamorized tournaments selling the premise that an ordinary person from any background can make extraordinary rewards. These same people would not get into the game if it were chess, the luck element has to be significant enough to mask the connection between skill set and rewards significantly. There are some "weighting" methods that apparently really work in the hands of a few with just the right talents and disposition, but these books present a moral hazard. For every one person who reads a little poker book and gets into the game with shears, a hundred others who have read the same book jump in to provide the fleece. So if value investing is based on a world of irrational people intermingled by a few whom are rational, and the situation can't be corrected by informational symmetry -- the market doesn't tend to efficiency, most pros can't even reproduce the results -- then it's basically as self-sustaining racket. And the book rather than being information that does its civic duty in a market economy of providing correctives in exchange for a monetary reward for the practitioner, it's a sales pitch to bring in fresh meat. The benefit of the meat more than covering the cost of one or two more hungry mouths with the right skills.

Anyway, part of my issues here are "academic", but it's also a little personal too, as I've seen a few lose their shirts in the game; for one, it was an entire life's savings. Oh yeah, they all knew who Buffett was. Strategy is an open question, but does it matter? If not even the average pro can succeed with the right strategy, the little guy is hopeless, on average, to figure out what the right strategy is among all the possibilities, and then to properly implement it. But that's simply assumed in a market that is believed to be irrational. I know Buffet has expressed concern that his success doesn't seem right, but it is what it is.

I just have a hard time understanding the moral concerns of investment experts who promote their own brand of beating a market -- one they deny as self-correcting -- in very public ways. It just seems to me the moral high ground here is better had by either the index fund manager, or those who condemn the whole thing as a racket, but aren't benefiting substantially from participating in the racket, and popularizing the racket in books, the news, TV, seminars, etc.

[_EAllusion]

When I've "invested' in Intrade, which is essentially no different than gambling, I haven't made my buy and sell decisions merely based on changing projections in what I think is going to be the outcome that pays out on the "stock". In fact, that's had very little to do with my decisions at all. Rather, my decisions were based on projecting how the crowd was going to behave based on changing information and trying to beat that crowd accordingly. Buy low and sell high. I've consistently made money because the crowd has been irrational in predictable ways. I made a nice gain by correctly predicting various presidential candidates would be overvalued at particular election points, for instance. I've been able to leverage my knowledge of political forecasting against common misconceptions about elections that pervade the general culture.

While my real investing is just passive investment in index funds, I gather that stock traders don't simply speculate in future value of a company based on its fundamentals, but also try to project the behavior of the crowd to get a step ahead. If you think a crowd is going to overvalue or undervalue something relative to its "real" worth, it's still in your interest to buy or sell accordingly. That behavior can and should create more wild swings in price due to prediction feedback loops.

[_Gadianton]

While my real investing is just passive investment in index funds, I gather that stock traders don't simply speculate in future value of a company based on its fundamentals, but also try to project the behavior of the crowd to get a step ahead. If you think a crowd is going to overvalue or undervalue something relative to its "real" worth, it's still in your interest to buy or sell accordingly.

This IS speculating based on fundamentals. If a market is driving the price of Microsoft past the point where its price to earning ratio is justified, then you're going to short the stock. If you have a trading scheme based on crowd psychology, you believe you know how the crowd moves, then you would take more of an agnostic stance toward what the price "should" be, such as when doing technical analysis. There are volume trading schemes, where volume indicates an intense interest in the stock. Noise trading broadly describes these activities. If you bet based on crowd psychology, then while inefficiency may be implied, you're more agnostic to that, and simply interested in the equations or common sense intution that describes the direction of the crowd. To illustrate the point, a crowd could maintain a price well above the real worth of the stock for years -- in the inefficient market most people believe describes reality -- but a fundamental analyst would lose his shirt because the "real worth" has to manifest manifest itself within the bounds of his short sale, in my example. A crowd psychologist doesn't care where ground zero is, as long as he can predict the direction of the crowd, he can make money.

That behavior can and should create more wild swings in price due to prediction feedback loops.

Here's one description:

Studies have found that mutual fund inflows are positively correlated with market returns. Momentum plays a part in the decision to invest and when more people invest, the market goes up, encouraging even more people to buy. It's a positive feedback loop.

Read more: http://www.investopedia.com/articles/07 ... z2F8QSKeIx
(don't forget to pick up the FOREX trading essentials book advertised next to the sentence I quoted :)

The argument against this is covered under weak efficiency, the random walk, that argues technical analysis doesn't work because it's easy to do. Since behavioral economics is more recent and I haven't read a great deal about it, I'd have to do some research to see if behavioral trading schemes are all considered to fall under weak efficiency, I'm guessing yes, for now.

To argue against what I just wrote, take the case of a bubble. Efficiency says bubbles shouldn't happen, yet, it's trivial to demonstrate that when the market as a whole tanks over several weeks, that the prices of stocks begin to correlate with each other, which violates the random walk. This doesn't demand that efficiency is false, but it's a serious challenge to the theory. Less serious are isolated instances of "feedback loops" of individual stocks and so on left without arbitrage because of the possibility of seeing faces in a cloud. Anyway, as I've said in a previous post where the crash is considered, here you have these massive, obvious prices correlations, but for all of those who have claimed to predicted the crash, it's interesting to read about some of those who didn't. Warren Buffett testified before congress that he didn't see it coming. He joked that if he had, he would have taken options positions. Warren Buffett is the single best argument against market efficiency. He testified that he rejects market efficiency. Market efficiency's over-arching test is that you can't beat the market, and Warran Buffett didn't beat the market in the single most obvious example of mob psychology that everyone cites as falsifying efficiency. Just something to think about -- it's a very challenging problem for everyone.

If behavioral economics takes over and becomes the new paradigm, this raises some big question. For one, if market participants all become educated in how markets behaves, then they'll correct the market, eliminating the "irrational" behavior. If the new behavioral model leaves the market fundamentally uncorrectable, which is a possibility, then this is bad news for libertarians. What it means is the situation is similar to my last post to Analytics, in that scenario, the wolves perpetually feed on the flock. It may be in our interest to regulate markets much more than we are currently doing, or even government to play a primary role in how capital allocations are made. The trader/liberal position that Analytics takes, even though I disagree with it, can be entirely consistent, more consistant than the common conservative positions are.

[_EAllusion]

This IS speculating based on fundamentals.

Intrade is a prediction market that allows people to trade a stock that will pay out 2:1 if a particular event happens. This provides a more final reckoning of a stock's true value compared to, say dividend payouts, but it is highly analogous. Because of the nature of the participants and the relatively low volume (I suspect) it has foibles that can be habitually exploited. For example, conservatives are disproportionately represented among the traders. Conservatives consistently mildly to moderately overestimate the chances of conservative political victories because of bias in their media consumption. As a consequence, Intrade offers many slightly overpriced predictions of conservative political victory.

Let me give a specific example I talked about on this board before doing it:

Prior to the South Carolina primary, Newt Gingrich was trading at a relatively low number. As it became increasingly clear that he had a very good chance of having a strong victory in that state, I decided that buying his stock would be smart. I decided this because I predicted his victory would result in a price spike due to two factors. First, Intrade market psychology consistently overvalues underdogs when they receive media coverage and second because the media would likely pour in pundit commentary that would overstate Gingrich's chances and mislead people. I'd then sell a few days later, which I did, trying to avoid the downside of the price spike. I made a huge % gain off of that bet.

Now as it happens, I really thought Gingrich's victory marginally increased his chances way below the % change that happened. I also thought Gingrich's chances were overestimated even prior to the price spike. I bought "low" at a pricepoint I already thought was wrong relative to the real odds. That's what all good forecast modeling was showing. Fortunately, many market participants aren't forecasting nerds despite their gambling on forecasting. But whether the spike represented an overvaluing or not wasn't strictly important to me. I was just interested in what I predicted the crowd would do and trying to beat it. I wasn't waiting for any final reckoning of the numbers because I got in and out before the actual prediction event occurred. I thought event X was going to lead to market behavior Y with the underlying real likelihood only partially informing that behavior. If that's still fundamental analysis, fine, but I think that's just getting the jargon right.

I'd be shocked if this sort of thing didn't occur in, say, commodities markets where the parallels are sound. Whether there is irrationality to exploit in the case of that I don't know as the volume and sophistication of the players is so much higher. I do know that traders doing huge volumes have admitted to consulting astrologers to guide their decisions, so it wouldn't be shocking to me if there are exploitable moments.

[_Gadianton]

EMH, though you may already know this, was a thesis about the stock market as an "efficient market", not all markets. Though in abstract, the principle could be seen as an update to law of one price, or perfect markets. In particular, it was believed the stock market would be the most obvious example of a market that is in equlibrium. But similar insights in macroeconomics invented rational expectations, where it is far less intuitive that the economy could perpetually be in equilibrium, but that's the idea. So at a certain point, the "one price" idea should extend to intrade, but intrade does not necessarily test EMH. Thomas Sargent won a nobel prize last year (?) for his work in rational expectations, but as one might expect, the theory is emperically more difficult to justify than EMH. (by the way, whatever empirical problems EMH may have, economics theories typically have a lot of empirical problems, and relatively speaking, I wonder how many have better support. My guess is few, if any, but since these topics have been coming up and i've been responding, i'll keep an eye out. Up until the time Droopy got me interested in the Austrian School, I'd probably spent less than a couple hours a year thinking about economics in the last decade, so I'm not "up to speed" on what's out there.)

I haven't read about information efficiency for any other market than the stock market and FOREX. I was interested in FOREX a long time ago as it seemed weekend warriors were jumping ship from Wall Street to the much bigger frontier of currency speculation. The studies I read claimed to be encouraging, but the quality of data lower etc. and the initial verdict was good, but not as good as for stock market efficiency.

To the extent that any derivatives market drastically fails to tend its underlying assets to efficiency, or worse, creates more inefficiency, then I think it's a social evil, and should be eliminated.

Anyway, just fyi, i'm signing off on this forum until Jan. 15 or later to keep the dismal science from working in the back of my mind over the holidays. I'll respond to any other quesitons or objections then. I also really want to talk about "rationality" as the word is horribly problematic in discussions about econ i've seen and a lot of that is the fault of economists working their jabs in the public forum. I think people talk past each other all the time, end up representing positions they don't intend to etc., and it becomes highly confusing about what the subject actually is if people aren't using a key word in the same way.

[_Analytics]

The stock price is a reflection of the future value of a share in the company. Since no one can know the future, the stock price fluctuates as stock buyers and sellers adjust their best guesses....

I like this answer. If I had to give a textbook answer, it would be similar to what I think you're saying, I'd say the stock price is the present value of future returns out to infinity. But I don't think the teacher would be happy with this answer, he wants to know what company fundamentals justify the stock price. As you point out, that's difficult.

I'd feel like he's trying to trap me into doing fundamental analysis, which is contrary to the gospel.

I’d suggest the price of a stock is simply the point where the supply and demand for a share of the stock meet—the price is nothing more nor less than what the market says it is.

In contrast, the value of the stock is the present value of all expected dividends—any other valuation just wouldn’t make sense. Now, there can be different views about what those expected dividends are, how much risk is involved, and what rate of discounting should be used.

Please don’t be offended by me telling you what you believe, but your religion is founded on the belief that the price of a stock is equal to the market’s evaluation of its value, and that an individual can’t evaluate the price of a stock better than the market itself.

To the average person post-crash, it might seem that economists have been completely stupid, of course investors are irrational, this has to be the way to go. But the framework is extremely limited here, what does a model of an irrational world look like?

It depends upon the purpose of the model. All models have assumptions. The assumptions can either be good, bad, or ugly. That's okay--if the model provides useful results by all means use it--my simple point is that not everything that is useful is true.

There are further implications for an irrational world as well, if policy making is tough in a world where people are rational, I don't know how policy makers are going to fix irrationality.

You have to understand the specifics of how they are irrational. A perfect example is the way Bush and Obama implemented tax cuts. Send everybody a check, and their irrationality results in more political points. Quietly lower their tax withholdings, and their irrationality leads to a little more stimulus.

[_Analytics]

To me, the world you paint is much like the exploding poker industry. Poker is a skill-based game but with a lot of uncertainty about the value of a hand and therefore, big rewards and losses that aren't always easy to match up to what is skill and what is luck....

Excellent analogy.

Anyway, part of my issues here are "academic", but it's also a little personal too, as I've seen a few lose their shirts in the game; for one, it was an entire life's savings. Oh yeah, they all knew who Buffett was. Strategy is an open question, but does it matter? If not even the average pro can succeed with the right strategy, the little guy is hopeless…

Fair point. Greenblatt talks a lot about this. Although he wrote “a little book”, he tells his readers that correctly evaluating the true value of a security is difficult, and that the vast majority of people are incapable of doing it well, and that they’ll likely lose their shirt if they try.

He claims that for the value strategy to work, you need a long time horizon. You’ll have good years, but you’ll have some series of awful years. He claims that professional managers have their hands tied here—as a general rule, a value strategy is a contrarian strategy—you are buying stocks that are out of favor with others. These stocks do in fact often have bad results—especially in the short-term. You need to have a lot of patience, faith, and a long horizon to make it work. Even if a professional manager understands this, that doesn’t mean his clients and his boss will. After all, the systematic irrationality of the public is exhibited not only by those who purchase individual stocks, but by those who invest in mutual funds.

I just have a hard time understanding the moral concerns of investment experts who promote their own brand of beating a market -- one they deny as self-correcting -- in very public ways. It just seems to me the moral high ground here is better had by either the index fund manager, or those who condemn the whole thing as a racket, but aren't benefiting substantially from participating in the racket, and popularizing the racket in books, the news, TV, seminars, etc.

I share the same skepticism of investment experts as a group. That is why I’ve only found two standard works for my canon: The Little Book that Beat the Market and The Value Line Survey.

[_Analytics]

When I've "invested' in Intrade, which is essentially no different than gambling, I haven't made my buy and sell decisions merely based on changing projections in what I think is going to be the outcome that pays out on the "stock". In fact, that's had very little to do with my decisions at all. Rather, my decisions were based on projecting how the crowd was going to behave based on changing information and trying to beat that crowd accordingly.

The vast majority of stock investing is done the same way, which is what makes a value strategy viable. Even if you try to implement a value strategy, it's really hard to have the discipline to stick with it when your emotions and the crowd are telling you to do something else.