Get Rich by Destroying Wealth

[Anonymous]

This is an argument that is made against "the guru investors" like Greenblatt all the time. The Gurus have a career-based interest in market efficiency being false. If market efficiency is true, then investing is a crapshoot. If it's false, then laymen are taking on an army of financial experts and hoping to beat them in a complex, competitive game with big money at stake, by following "a few easy steps".

I agree 100%.

Absolutely. EMH is the argument for the index fund. An index fund manager has a moral right AND a financial incentive to accuse active fund managers of "stealing," so all the merrier. :) From a EMH/passive perspective, it would be like hiring an expert to spin the roulette wheel for you, and then paying him a commission for it no matter what the outcome.

I love the roulette metaphor, but must point out that the Godfather of index funds disagrees about what the argument--at least at Vanguard--actually is. He says in the book, "I’ve often noted, we didn’t rely on the EMH as the basis for our conviction. After all, sometimes the markets are highly efficient, sometimes wildly inefficient, and it’s not easy to know the difference. Rather, we relied on a theory that is not only more compelling, but unarguably universal. The CMH--the Cost Matters Hypothesis--is all that is needed to explain why indexing must and will work. "

Thanks for bringing up Droopy, now we're bringing out the heavy artillery. Droopy wouldn't be outraged, because Droopy would not accept the premise, as one who follows the Austrian School. The Austrians, along with most "leftists" reject market efficiency. They publish papers against market efficiency in their journal, and many active fund/hedge fund managers are, in fact, die-hard Austrians, including a nephew of Cleon Skousen's. Now, are you sure you're not ready to convert?

Why do I feel all-of-a-sudden icky? Lol.

when I pull the trigger at Fidelity for $542.2401 per share, I am in fact getting the very best price available anywhere

It depends on what you mean by "best". If you mean lowest, then certainly not, it would be better to find the share in a market where the stock goes for less. If it goes for $542.2401 on the NYSE and $420 at AMEX, then you buy at AMEX.....

...and instantaneously sell on the NYSE, making money without any downside risk. But unless I’m able to pull off those transactions in literally a matter of nanoseconds from the instant the prices diverged, the folks who do-so for a living will have already done so, and forced the prices to converge. That was my point--the fact that they do in fact do this adds value to the world because it frees people like me from the burden of having to shop around in order to get the best available price.

"But what if the bread-arbitrager needs to cut a hole in the baker’s wall in order to make these transactions..

This is where I'm losing you. Are you saying the market makers are profiteering in transaction costs? There is surely some truth to this, and to the extent the market is being "churned" over and above market efficiency, it is "unfair". But your comment about the explosion I can't place....

I was wondering if you’d see through that particular parable. The 0.5% of the time that the bakery explodes refers to the 0.5% of the time when the MOU’s (Masters of the Universe’s) models blow up, causing system-wide calamity. The MOU’s activities theoretically lead to consistent, risk-free profits that are well above the market risk-free rate. But in reality, the assumptions in their models aren’t always true. The 0.5% of the time that the assumptions don’t prove true, what we find out is that their activities didn’t eliminate risk--it did the opposite and concentrated it. The explosion can be anything from a flash-crash that temporarily closes the markets to a debacle on the scale of LTCM, Bear Stearns, or Lehman Brothers. The MOU gets the upside benefit, but the explosion causes others to take major hits on the downside risk.

After your conversion, we can stand together and expose the hedge fund managers, and slowly, the market for fund managers will become competitive to the point where passive portfolios with low fees are the rule. Until then, "the little books" out there will only encourage people to think that the ordinary "little" person can beat big bad Wall Street at their own game...so I will happily throw all the trading books in the fire along with the holy books of the world and leave it at that. I realize most people will keep their favorites. But it's kind of interesting because market gurus will denounce market efficiency like preachers denounce atheism, but when pressed, they'll concede that market efficiency is nearly true, they, after all, believe in only one more God than the atheist does.

LOL. How long ago did you get your CFA? Your faith in EMH has the certitude and zeal of a missionary fresh out of the MTC.

I do reject the efficient market hypothesis, CAPM, and all the rest (really, “all investors are rational mean-variance optimizers, meaning that they all use the Markowitz portfolio selection model”??! Give me a break).

Fine. But just to point it out, EMH is real economics, with a real body of literature behind it that includes extensive empirical studies, and it is taught at real universities and business schools, including MIT, and is a standard subject of finance and financial economics textbooks. ...

Of course. That is one of the reasons I find Greenblatt’s “Magic Formula” so intriguing. Professor Greenblatt says that every semester he teaches course B9301-066 (Value & Special Situation Investment) at Columbia Business School, the first thing he talks about is the EMH. He says he begins every semester by picking a random stock from the WSJ, comparing its 365-high price to its 365-day low price, and asking the students to explain the price swing. He repeats the question for a few other stocks to drive home the fact that the stock market has a ton of volatility.--far more so that could be explained by real changes in the long-term prospects of the companies in question as evaluated by “steady, sophisticated, enlightened, and analytic” institutional professionals.

Yet the price swings persist.

It sounds to me like you're judging a good chunk of the framework of financial economics as not worthy of your time based on a couple of sentences you've read that rub you the wrong way. ...It is my opinion, however, that to properly evaluate the theory, you'd need to invest more time into understanding it. Not saying you SHOULD, as I think economics is a boring subject, just sayin'.

The irony, LOL. Since you broached the topic, I wonder if you'd reconsider your opinion on the matter given that I've invested enough hours endeavoring to understand this stuff to pass this exam and this exam and get my name on this list.

Just to point it out, all people are rational "mean-variance optimizers" in the world of Keynes as well, at least as it would be taught from a text at MIT, even if those precise terms aren't used. I may start a separate post explaining this at another time.

I’m not entirely sure I understand your point, but I think I strenuously disagree. I hope you start that thread.

[_Analytics]

Here is the specific quote from that investment snake oil salesman I referenced:

For the past nine years, I have taught an investing course to a group of graduate business students at an Ivy League university. Needless to say, this is a pretty smart group of students. Each year, on the first day of class, I walk in and open the newspaper to the financial section….

“Call out the name of a big, well-known company,” I say…

I look in the paper next to General Electric and read off the numbers. “It says here that the price of one share of General Electric was $35 yesterday. It also says here that the highest price that General Electric shares have sold for over the last year was $53 per share. The lowest price for a share over the last year was $29….”

So here’s the question that I always ask: How can this be? These are big, well-known companies…

So I ask the question again: How can this be? Can the value of General Motors, the largest care manufacturer in North America, change that much within the same year? Can a company that large be worth $30 billion one day and then a few months later be worth $60 billion? Are they selling twice as much cars, making twice as much money….Of course it is possible. But what about the big price changes in IBM, Abercrombie & Fitch, and General Electric?...

Remember, every year the results are the same. For pretty much any company that my students name, the range of high and low prices, over the course of only one year, is huge. Does this make sense?...

So I ask my room full of smart, sophisticated students to try and explain why. Why do the prices of all these businesses move around so much each year if the values of their businesses can’t possibly change that much?

If you were in his class at Columbia, how would you answer?

[_cinepro]

If you were in his class at Columbia, how would you answer?

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.

[Anonymous]

Hey Gad,

The irony in some of your comments is just so rich I can’t stop thinking about it.

Earlier you said,

Proprietary or not, that's fundamental analysis, it is precisely, active fund management, the nemesis of Bogle. The label Greenblat ascribes to his strategy, "value investing" is meaningless as a point to differentiate his strategy from others, from "good investing" vs. "bad speculating".

You went on to say…

No doubt the two books you've recommended are interesting, but the work of Chicago will long outlive them.

Here are some points you might find interesting.

The term “Value Investing” is a well-defined investment strategy that was invented by Benjamin Graham and David Dodd in the 1920’s at Columbia University.

In his latest book, Bogle mentions the EFM once or twice, always in the context of it not being true. In contrast, he mentions Benjamin Graham about a dozen times, invariably with lavish phrase. For example, Bogle said: ”We know—we know—that in the long run, market returns represent the triumph of investment fundamentals—earnings and dividends—over speculation in the market’s valuation of these returns. Yet during the recent era, it is speculation that has been in the driver’s seat. We continue to ignore Benjamin Graham’s profound wisdom, cited at the outset: ‘In the short run, the stock market is a voting machine; in the long run it is a weighing machine.’”

That’s what the godfather of index funds thinks thinks.

But will Modern Portfolio Theory outlive value investing on the elite bookshelves of the educated? From Columbia University’s website, “The Heilbrunn Center for Graham & Dodd Investing was established in 2001 to ensure a permanent home for value investing at the Columbia Business School.” And of course, Columbia’s Heilbrunn Center for Graham & Dodd Investing is where Greenblatt is an adjunct professor.

I saw a cool youtube video that brings together the relationship between value investing and index fund investing. After a presentation at Columbia University, Warren Buffett was asked by a student, “How would you recommend an individual investor who follows the Graham and Dodd philosophy to allocate their capital today?”

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.

http://www.youtube.com/watch?v=dX2L7JhpXl8

[_Analytics]

If you were in his class at Columbia, how would you answer?

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.

Not a bad answer, but it leaves me disturbed: you really think the aggregate wisdom of the expert players in the market is so whimsical and uncertain that their very best guesses of the valuations of companies will swing as much as they do?

[_Gadianton]

..The CMH--the Cost Matters Hypothesis--is all that is needed to explain why indexing must and will work..

Looked this up and discovered it's a Vangaard thing. Are there any formal economics papers that define CMH? Reading through some of the internet back-and-forth on the subject, since that might be all we have, maybe CMH could be derived formally independent of EMH, but the historic and practical underpinning of EMH in CMH is obvious, and even reflected in the name. At any rate, if CMH defines the true model of the economy, then it sounds to me like there's an unclaimed Noble Prize waiting.

EMH will be difficult to overthrow because when you get past all the religion, it's nothing more than an equilibrium model. All of formal economics is discussed in terms of equilibrium models. The only folks alive today I'm aware of who explicitly have a problem with this are the Austrians. The financial community likes to have their cake and eat it too.

But unless I’m able to pull off those transactions in literally a matter of nanoseconds from the instant the prices diverged, the folks who do-so for a living will have already done so, and forced the prices to converge. That was my point--the fact that they do in fact do this adds value to the world because it frees people like me from the burden of having to shop around in order to get the best available price.

Assuming "best" means "most accurate," I'll have to quibble here, as the arbitrage opportunities have not all been exploited at this point. Remember, Greenblatt is in the business of spotting over or underpriced securities and arbitraging. So if you want the most accurate price, you will have to buy from Greenblatt. I see that "Value Investing" is widely regarded by investment communities as an example of a strategy that beats the market, so in regards to all arbitragers, why haven't "the folks who do-so for a living will have already done so, and forced the prices to converge?"

And why publish your money tree? if the price of securities do not reflect all available information and the market is not, therefore, efficient, why publish that little bit of information that isn't available?! The nice thing about efficient markets is that they win, even when they lose. :)

The MOU’s activities theoretically lead to consistent, risk-free profits that are well above the market risk-free rate. But in reality, the assumptions in their models aren’t always true

Sounds like a conspiracy theory, but what it comes down to is that I'm just not in a position to evaluate the claim here because I still don't understand the claim. Is this information discussed only in Bogle's book, are there other free sources online or some key words I can look up? As one might guess, market efficiency studies have delved into the subject of exactly how many seconds are available to exploit arbitrage opportunities.

LOL. How long ago did you get your CFA?

I didn't go for it due to my apostasy from the field early on.

the first thing he talks about is the EMH.

Thank you, at least we're all in agreement on what the model is. These practitioners, who are often found in business schools and sometimes but less often, found in economics departments, remind me of Stephen J. Gould who lambasted evolutionary theory and the acadamy founded upon it, but in reality, wasn't really offering an alternative that could hope to rewrite history.

Yet the price swings persist.

It's amazing that they do given growing number of value investors, whose actions should be correcting the price swings. And if the price swings are erratic and unjustified as seemingly implied, the value investors should not only be rich, but market-power rich.

Once the world is converted to value investing, will you then, at that point, admit that the market is efficient? Or is there really a long-term alternative as the true model of the economy?

The irony, LOL. Since you broached the topic, I wonder if you'd reconsider your opinion on the matter given that I've invested enough hours..

Not at all. We've known each other a while, and I know you are an actuary, hence, your name. Let's just get this out of the way: If we both started economics grad school today, I'm sure you'd do better than me. Math is the language of science, and it would take me a long time to catch up to where I was back in the day, and then from there, fill in the difference between where I left off and a professional actuary. But math does not exhaust this subject.

The CFA is difficult, but it's arguably undergrad-level material still, depending on the school. The CAPM is inadequate, but it's a good heuristic for pricing in context of market efficiency. The day I was taught it, I was not only taught that practitioners were up in the night, but that the CAPM is wrong. It's probably a good thing, since it's just a simple regression model that would hardly keep a Phd interested for long. There are calander anomalies and small stock anomalies that beat CAPM, so there are probably some trading strategies that can be shown to beat CAPM as well. This has all been known for a long time, and even Eugene Fama has published to falsify CAPM. There are more sophisticated models that fix anamolies, and EMH itself is still the model until it isn't.

As for Keynes, yeah, I'll start that discussion. But first, why do YOU reject that all agents are rational, mean-variance optimizers? I'm nearly 100% sure I know what you're going to say, but I want it in print, before I begin the topic.

[_Gadianton]

But will Modern Portfolio Theory outlive value investing on the elite bookshelves of the educated? From Columbia University’s website, “The Heilbrunn Center for Graham & Dodd Investing was established in 2001 to ensure a permanent home for value investing at the Columbia Business School.” And of course, Columbia’s Heilbrunn Center for Graham & Dodd Investing is where Greenblatt is an adjunct professor.

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

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. 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. When it's overthrown, a lot of books will have to be rewritten and a lot of computers on Wall Street reprogrammed, despite the fact that everyone seems to be a critic of the idea. Heck, there was even a Noble Prize given out for a theory contradicting market efficiency, yet EMH is still the textbook material.

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?

[_Analytics]

..The CMH--the Cost Matters Hypothesis--is all that is needed to explain why indexing must and will work..

Looked this up and discovered it's a Vangaard thing. Are there any formal economics papers that define CMH? Reading through some of the internet back-and-forth on the subject, since that might be all we have, maybe CMH could be derived formally independent of EMH, but the historic and practical underpinning of EMH in CMH is obvious, and even reflected in the name. At any rate, if CMH defines the true model of the economy, then it sounds to me like there's an unclaimed Noble Prize waiting.

The term “CMH” itself is slightly tongue-in-cheek, but the truth of the matter is tautologically simple, which is why it wouldn’t be published in a paper or win a Noble Prize: in aggregate, the gross returns investors make is equal to the gross returns of the market itself, regardless of whether or not the market is efficient. If you invest in the entire market in such a way that your costs are less than the costs of others, your return net-of-costs will beat the aggregate return of the market as a whole, net-of-costs. That’s all there is to it.

EMH will be difficult to overthrow because when you get past all the religion, it's nothing more than an equilibrium model. All of formal economics is discussed in terms of equilibrium models. The only folks alive today I'm aware of who explicitly have a problem with this are the Austrians. The financial community likes to have their cake and eat it too.

This reminds me of conversations I used to have with Juliann. She was really high on Sociology models that assumed that people were rational decision makers. Whenever questions that touched upon whether being a Mormon was a rational decision, she’d counter with this argument: A- people are rational decision makers, B- people believe in Mormonism, therefore C- being a Mormon is a rational decision.

I hope you see my problem with the logic. The truth is in behavioral economics—rather than making the absurd assumption that people are rational and then admiring the equilibrium that results, study and understand their irrationality itself.

But unless I’m able to pull off those transactions in literally a matter of nanoseconds from the instant the prices diverged, the folks who do-so for a living will have already done so….

Assuming "best" means "most accurate," I'll have to quibble here, as the arbitrage opportunities have not all been exploited at this point. Remember, Greenblatt is in the business of spotting over or underpriced securities and arbitraging….

Not exactly. A strict definition of arbitrage means you enter into a set of transactions were you have a possibility of making money, but no possibility of losing money. So engaging in his investment strategy in a true arbitrage fashion would entail purchasing the value portfolio with funds generated from short-selling the market portfolio. A confident arbitrager would do so on a scale large enough to change the prices to the point where the value portfolio wasn’t a value portfolio anymore.

And why publish your money tree? if the price of securities do not reflect all available information and the market is not, therefore, efficient, why publish that little bit of information that isn't available?! The nice thing about efficient markets is that they win, even when they lose. :)

In Greenblatt’s case, it’s a combination of sincerely deriving utility from the joy of educating others, along with a fair amount of vanity.

Sounds like a conspiracy theory, but what it comes down to is that I'm just not in a position to evaluate the claim here because I still don't understand the claim. Is this information discussed only in Bogle's book, are there other free sources online or some key words I can look up? As one might guess, market efficiency studies have delved into the subject of exactly how many seconds are available to exploit arbitrage opportunities.

I’d highly recommend you read The Black Swan by Nassim Taleb. In the meantime, you can start here:

http://en.wikipedia.org/wiki/Black_swan_theory

The basic point is that every theory is only a theory. When you take a theory that involves leverage or arbitrage into the real world, it can seem to be going perfectly for a while, but sooner or later something unexpected will happen and the thing that made the perpetrators wealthy and was supposed to be risk-free can blow up with the force of a hydrogen bomb and bring down the financial markets of the world. The blowup of LTCM (http://en.wikipedia.org/wiki/LTCM) is an early example of this.

Yet the price swings persist.

It's amazing that they do given growing number of value investors, whose actions should be correcting the price swings. And if the price swings are erratic and unjustified as seemingly implied, the value investors should not only be rich, but market-power rich.

If you and me were the two economists who were walking across campus, I’d be the one that said, “look, there is a $20 on the ground right there!” You’d be the one who replied, “That’s impossible. If it were there, somebody would have picked it up by now.”

Once the world is converted to value investing, will you then, at that point, admit that the market is efficient? Or is there really a long-term alternative as the true model of the economy?

At that point it will in fact become efficient, and I project it will happen on the day Congress votes to remove “one nation under God” from the currency.

The irony, LOL. Since you broached the topic, I wonder if you'd reconsider your opinion on the matter given that I've invested enough hours..

Not at all. We've known each other a while, and I know you are an actuary, hence, your name. Let's just get this out of the way: If we both started economics grad school today…

If you know me, I’ll occasionally lean on my credentials to at least be listened to, but I’d never use them as a club in an argument.

The actuary exams are about one-third math and statistics, one-third on the modeling insurance contracts and liability portfolios, and one-third investments and finance. I’d estimate I’ve spent 8,000 hours studying for actuarial exams. Of that, a solid 2,000 hours was spent studying the finer points of investments with a heavy emphasis on portfolio theory, EMH, arbitrage-free pricing, put-call parity, Black-Scholes, and all the rest.

I keep the book Investments by Bodie et. al. is on my shelf. It’s worn-out from me having read it multiple times attempting to learn by heart all of its arguments and formulas. It covers modern portfolio theory on the level of what you’d see on the CFA exams. In the preface, it says that “The common theme unifying this book is that security markets are nearly efficient, meaning most securities are usually priced appropriately given their risk and return attributes.”

I assumed you had a CFA or MBA because the stuff you’ve been saying comes right out of that book.

None of that means I know what I’m talking about, of course. It just means that being told I need to invest more time trying to understand this stuff was the most ironic think I’ve heard since I was told immediately after leaving the church that I really ought to pray about it.

As for Keynes, yeah, I'll start that discussion. But first, why do YOU reject that all agents are rational, mean-variance optimizers? I'm nearly 100% sure I know what you're going to say, but I want it in print, before I begin the topic.

I’m guessing you think I’m going to make an appeal to the inherent irrationality of human beings, as documented in the field of the psychology of decision-making?

More to the point, most people aren’t rational mean-variance optimizers because even if that is what they are trying to do, the perceptions of mean and variance on which they are optimizing aren’t rational in-and-of themselves.

[_cinepro]

Not a bad answer, but it leaves me disturbed: you really think the aggregate wisdom of the expert players in the market is so whimsical and uncertain that their very best guesses of the valuations of companies will swing as much as they do?

Considering all the different reasons people might buy or sell a stock, I suspect "aggregate wisdom" is only one factor.

[_Analytics]

Not a bad answer, but it leaves me disturbed: you really think the aggregate wisdom of the expert players in the market is so whimsical and uncertain that their very best guesses of the valuations of companies will swing as much as they do?

Considering all the different reasons people might buy or sell a stock, I suspect "aggregate wisdom" is only one factor.

True. The answer to this question the Columbia MBA professor would give, and I quote, "People just go nuts a lot."