Efficient Market Hypothesis

Efficient Market Hypothesis

Postby winston » Mon May 12, 2008 2:12 pm

Efficient Market Hypothesis
Ergodicity by John Mauldin

In the mutual fund and hedge fund world, one of the continual issues of reporting returns is something called "survivorship bias."

Let's say you start with a universe of 1,000 funds. After five years, only 800 of those funds are still in business. The other 200 had dismal results, were unable to attract money, and simply folded.

If you look at the annual returns of the 800 funds, you get one average number. But if you add in the returns of the 200 failures, the average return is much lower. The databases most statistics are based upon only look at the survivors. This sets up false expectations for investors, as it raises the average.

Taleb gave me an insight for which I will always be grateful. He points out that because of chance and survivorship bias, investors are only likely to find out about the winners. Indeed, who goes around trying to sell you the losers? The likelihood of being shown an investment or a stock which has flipped heads five times in a row are very high. But chances are, that hot investment you are shown is a result of randomness.

You are much more likely to have success hunting on your own. The exception, of course, would be my clients. (Note to regulators: that last sentence is a literary device called a weak attempt at humor. It is not meant to be taken literally.)

That brings us to the principle of Ergodicity, "...namely, that time will eliminate the annoying effects of randomness. Looking forward, in spite of the fact that these managers were profitable in the past five years, we expect them to break even in any future time period. They will fare no better than those of the initial cohort who failed earlier in the exercise. Ah, the long term." (Taleb)
It's all about "how much you made when you were right" & "how little you lost when you were wrong"
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Efficient Market Hypothesis

Postby winston » Mon May 12, 2008 2:31 pm

Tails You Lose, Heads I Win by John Mauldin

I cannot recommend highly enough a marvelous book by Nassim Nicholas Taleb, called Fooled by Randomness. The sub-title is "The Hidden Role of Chance in the Markets and in Life."

I consider it essential reading for all investors, and would go so far as to say that you should not invest in anything without reading this book. He looks at the role of chance in the marketplace. Taleb is a man who is obsessed with the role of chance, and he gives us a very thorough treatment.

He also has a gift for expressing complex statistical problems in a very understandable manner. I intend to read the last half of this book at least once a year to remind me of some of these principles. Let's look at just a few of his thoughts.

Assume you have 10,000 people who flip a coin once a year. After five years, you will have 313 people who have come up with heads five times in a row. If you put suits on them and sit them in glass offices, call them a mutual or a hedge fund, they will be managing a billion dollars.

They will absolutely believe they have figured out the secret to investing that all the other losers haven't discerned. Their seven-figure salaries prove it.

The next year, 157 of them will blow up. With my power of analysis, I can predict which one will blow up. It will be the one in which you invest!
It's all about "how much you made when you were right" & "how little you lost when you were wrong"
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Efficient Market Hypothesis

Postby winston » Mon May 12, 2008 2:39 pm

Investors Behaving Badly by John Mauldin

The Financial Research Corporation released a study prior to the [2001-02] bear market which showed that the average mutual fund's three-year return was 10.92%, while the average investor in those same periods gained only 8.7%. The reason was simple: investors were chasing the hot sectors and funds.

If you study just the last three years, my guess is those numbers will be worse. "The study found that the current average holding period was around 2.9 years for a typical investor, which is significantly shorter than the 5.5-year holding period of just five years ago.

[While the research below is from a few years ago, recent studies show exactly the same, if not worse, results. Investors in general are not getting any better.]

"Many investors are purchasing funds based on past performance,
usually when the fund is at or near its peak. For example, $91 billion of new cash flowed into funds just after they experienced their "best performing" quarter. In contrast, only $6.5 billion in new money flowed into funds after their worst performing quarter." (from a newsletter by Dunham and Associates)

I have seen numerous studies similar to the one above. They all show the same thing: that the average investor does not get average performance. Many studies show statistics which are much worse.

The study also showed something I had observed anecdotally, for which there was no evidence. Past performance was a good predictor of future relative performance in the fixed-income markets and international equity (stock) funds, but there was no statistically significant way to rely on past performance in the domestic (US) stock equity mutual funds. I will comment on why I believe this is so later on.

"The oft-repeated legal disclosure that past performance is no guarantee of future results is true at two levels:

1. Absolute returns cannot be guaranteed with any confidence. There is too much variability for each broad asset class over multiple time periods. Stocks in general may provide 5-10% returns during one decade, 10-20% during the next decade, and then return back to the 5-10% range.

2. Absolute rankings also cannot be predicted with any certainty. This is caused by too much relative variability within specific investment objectives. #1 funds can regress to the average or fall far below the average over subsequent periods, replaced by funds that may have had very low rankings at the start. The higher the ranking and the more narrowly you define that ranking (i.e. #1 vs. top-decile [top 10%] vs. top quartile [top 25%] vs. top half), the more unlikely it is that a fund can repeat at that level.

It is extremely unlikely to repeat as #1 in an objective with more than a few funds. It is very difficult to repeat in the top decile, challenging to repeat in the top quartile, and roughly a coin toss to repeat in the top half." (Financial Research Center)

This is in line with a study from the National Bureau of Economic Research. Only a very small percentage of companies can show merely above-average earnings growth for 10 years in a row. The percentage is not more than you would expect from simply random circumstances.

The chances of you picking a stock today that will be in the top 25% of all companies every year for the next ten years are 1 in 50 or worse. In fact, the longer a company shows positive earnings growth and outstanding performance, the more likely it is to have an off year. Being on top for an extended period of time is an extremely difficult feat.

Yet, what is the basis for most stock analysts' predictions? Past performance and the optimistic projections of a management that gets compensated with stock options. What CEO will tell you his stock is overpriced? His staff and board will kill him, as their options will be worthless.

Analysts make the fatally flawed assumption that because a company has grown 25% a year for five years that it will do so for the next five. The actual results for the last 50 years show the likelihood of that happening is very small.
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Efficient Market Hypothesis

Postby millionairemind » Mon May 12, 2008 2:41 pm

Taleb wrote 2 books.. Fooled by Randomness and The Black Swan.. both are very interesting books.. though a little dry at the edges.

He poked fun at LTCM and the Black Scholes model of efficient mkt options pricing.

From my point of view.. the EMT is flawed cos' if the market is truly efficient.. it does not explain why WB and Peter Lynch both beat the market almost yearly...

Or how SAC Captial Advisors averaged 90% return year after year with a trend following trading model..

Guess you only need the existence of one black swan to prove the hypothesis that all swans are white is flawed.. :)
"If a speculator is correct half of the time, he is hitting a good average. Even being right 3 or 4 times out of 10 should yield a person a fortune if he has the sense to cut his losses quickly on the ventures where he has been wrong" - Bernard Baruch

Disclaimer - The author may at times own some of the stocks mentioned in this forum. All discussions are NOT to be construed as buy/sell recommendations. Readers are advised to do their own research and analysis.
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Efficient Market Hypothesis

Postby mojo_ » Mon May 12, 2008 3:06 pm

millionairemind wrote:He poked fun at LTCM and the Black Scholes model of efficient mkt options pricing.

From my point of view.. the EMT is flawed cos' if the market is truly efficient.. it does not explain why WB and Peter Lynch both beat the market almost yearly...

EMT implies human beings are rational (or emotionless) creatures... 'nuff said :? :)
Not what but when.
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Efficient Market Hypothesis

Postby b0rderc0llie » Mon May 12, 2008 4:25 pm

millionairemind wrote:Taleb wrote 2 books.. Fooled by Randomness and The Black Swan.. both are very interesting books.. though a little dry at the edges.


I've read Taleb's 2 books. Interesting concepts.
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Efficient Market Hypothesis

Postby HengHeng » Mon May 12, 2008 4:29 pm

Because WB and those great investors believe that market is always wrong. Prices then to react extremely to catalyst and more often overdo them. There given opportunities to beat the market
Beh Ki Jiu Lou , Beh lou Jiu Ki lor < Newton's law of gravity , but what don't might not come back

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Efficient Market Hypothesis

Postby millionairemind » Tue Mar 10, 2009 7:33 pm

Buttonwood
The grand illusion

Mar 5th 2009
From The Economist print edition
How efficient-market theory has been proved both wrong and right

THE past ten years have dealt a series of blows to efficient-market theory, the idea that asset prices accurately reflect all available information. In the late 1990s dotcom companies with no profits and barely any earnings were valued in billions of dollars; and in 2006 investors massively underestimated the risks in bundling together portfolios of American subprime mortgages.

There is now widespread acceptance that investors can behave irrationally, creating very large anomalies. Take the momentum effect, the practice of buying the stockmarket’s best performers over the previous time period. A study by the London Business School found that, since 1900, buying British stocks with the best momentum would have turned £1 into £1.95m (before costs and tax) by the end of last year; the same sum invested in the worst performers would have grown to just £31. In efficient markets, such an anomaly should be arbitraged away.

Belief in efficient-market theory made the authorities reluctant to restrain either the dotcom or the housing and credit bubbles. Perversely, the result has been much greater state interference in the markets than was dreamed of ten years ago, with commercial banks being nationalised or subsidised, and central banks acting as a buyer of last resort for financial assets.

But it is important not to throw out all the insights of efficient-market enthusiasts. Although it is theoretically possible to make money by outperforming the markets, it is extremely difficult in practice. That ought to have made investors suspicious of the smoothness of the returns of Bernard Madoff, who has been accused of a vast fraud. His strategy, as advertised, might have produced less volatile returns than the index, but the absence of negative months suggested almost perfect market timing.

Some fund managers have beaten the markets over long periods. The problem is to identify them in advance. Picking them after they have outperformed may be too late, as those who backed Legg Mason’s Bill Miller have recently discovered. Why is this? Fund managers are human too and subject to behavioural biases. In addition, the larger their funds become (as their reputation spreads), the more difficult it is to outperform.

The temptation has also been to assume that fees are positively correlated with performance—that if mutual fund managers charging 1.5% are good, hedge-fund managers charging 2% (and 20% of performance) are even better. Because investors cannot beat the market in aggregate, all this means is that money is transferred from investors to fund managers. Even David Swensen, the man who led the drive into alternative assets at Yale University, thinks most investors should rely on low-cost index-tracking funds.

But perhaps the area where the efficient-market hypothesis should have had greater weight is at banks. Many lament the demise of old-style banking, the “three-six-three” model where bankers borrowed money at 3%, lent it at 6% and were on the golf course at 3pm. That model broke down because markets were fairly efficient; the margins on lending to corporations became too low.

So banks were attracted to the higher-margin business of investment banking. Commercial banks could use their capital to back up their advisory operations and outmuscle old-style investment banks. The latter duly abandoned the partnership structure and raised money on the stockmarket, or were bought by commercial banks. The same logic required new trading desks to handle the banks’ positions, and those desks quickly became profit centres of their own.

But how were those trading desks making money? Perhaps they were exploiting information gathered by the rest of the group, a tactic that, if not illegal, put them in conflict with their clients. Or they were taking advantage of an artificially low cost of capital. With commercial banks, that cost was low because of the implicit public subsidy provided by deposit guarantees. Without such guarantees, savers would have wanted higher interest rates from banks with trading arms to reflect the risk of a market-related loss. In the good years, when they randomly beat the market, the traders earned bonuses. In the bad years, the taxpayers have picked up the bill.

And that raises a fundamental question. If regulators thought markets were too efficient to interfere with, how come they allowed banks to get involved in an activity which, after bonuses, was a game they collectively could not win?
"If a speculator is correct half of the time, he is hitting a good average. Even being right 3 or 4 times out of 10 should yield a person a fortune if he has the sense to cut his losses quickly on the ventures where he has been wrong" - Bernard Baruch

Disclaimer - The author may at times own some of the stocks mentioned in this forum. All discussions are NOT to be construed as buy/sell recommendations. Readers are advised to do their own research and analysis.
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Re: Efficient Market Hypothesis

Postby HengHeng » Tue Mar 10, 2009 10:46 pm

theories would always be theories .. thats y it is a HYPOTHESIS..

assuming an assumption in the perfect world under this scenario etc etc.. LOL

I rather believe in the greater bullshit theory ... who can bullshit and not get caught will be the eventual winner .. just look at poker .. trading and poker has the same theory ...

if you got good "cards" try to maximise your gains .. if you got lousy cards .. you can either bluff or just fold.. and take ur losses.. if you have lousy cards and insist on betting with no exit plan .. u will end up losing everything.
Beh Ki Jiu Lou , Beh lou Jiu Ki lor < Newton's law of gravity , but what don't might not come back

In the game of poker , "if you've been in the game 30mins and you don't know who the patsy is, you are the patsy
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Re: Efficient Market Hypothesis

Postby bertyeo » Wed Mar 11, 2009 12:06 am

the cards are created n printed by human being
"Die for something or Live for nothing"
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