Academia and the Random Walk

With the exception of a few, I think most would agree that academia could not translate theory into practice, nor could many fund managers translate their practical knowledge into academic theory. This unfortunately is due to the widely accepted concept known as Random Walk Theory. Many academics do not feel it is possible to add value, in terms of risk-adjusted returns, to investing. The Random Walk Theory asserts that it is impossible to outperform the market on a consistent basis. It views managers who empirically challenge this theory with skepticism suggesting chance correlation is more likely than proof that managers can outperform the market. They will generally agree that exceptional stock picking or market timing skills are not widely held among the many financial managers on Wall Street. I tend to agree that probably only a small percentage of Wall Street managers can actually beat the market, on a risk-adjusted basis consistently. But please do not misunderstand what I’m saying, I do believe it’s very possible to beat the market consistently. The only reason we do not see this more commonly is because the managers that can beat the market get over run by greed, causing them to lose sight of the basics. An example of this is Bill Miller. Bill Miller beat the S&P 500 index for 15 consecutive years from 1991 through 2005, but the current economic downturn has ended his streak. What happened? He lost sight of his basics which overexposed him to the financial downturn.

Academia generally holds the view that opportunities do not exist to add value to investing. If they believe in mispricings at all, they typically argue that one could not profit off of these mispricings successfullyenough to demonstrate, statistically speaking, that they have either stock picking or market timing abilities. This view holds relatively well considering it stems from the Efficient Market Hypothesis (EMH). I believe in the EMH, and this is why I believe it is possible to consistently beat the market on a risk-adjusted basis.

The Efficient Market Hypothesis suggests that stock market efficiency causes existing share prices to always reflect the most relevant information. As a result, stocks always trade at their fair value which in turn makes it impossible for investors to purchase undervalued or sell overvalued stocks. These assumptions imply exceptional stock picking or market timing impossible and the only way to obtain higher returns is by purchasing riskier investments. This is why the reference to risk-adjusted returns is so important. However, the three forms of market efficiency attempt to explain why such returns do happen.

Weak-Form Efficiency suggests that future stock prices cannot be predicted by analyzing historical stock prices. More specifically, this form implies that past returns are not indicative of future returns and that technical analysis cannot be used to exploit the markets. Weak-Form does believe certain fundamental analysis could provide excess returns to fund managers. Semi-Strong Form Efficiency suggests that share prices reflect all publicly available information and adjust to new information very quickly and in an unbiased manor. As a result, neither fundamental nor technical analysis techniques can be used to produce excess returns. Strong-Form Efficiency suggests that share prices reflect all information, public and private, and no one can earn excess returns.

Now that the three forms of efficiency have addressed, I will explain why I feel it is possible for us to have an efficient market and have people beat the very same market. First it should be noted that because people do earn excess returns, Strong-Form Efficiency does not hold. If Strong-Form is rejected, the possibility of having both an efficientmarket and people beating the same market very possible. I believe that markets are not efficient, but that they work towards efficiency as a result of the market participants. I believe that they never really achieve true efficiency because as they begin to converge to the truth, the truth changes. The truth can change for 2 reasons: 1) the facts have changed, that is new information enters the market or 2) enough market participants hold a contrarian view.

The purpose of the stock market side of this blogis to attempt to reveal that market fallacies exist. More specifically, the market fallacy that suggests consistent risk-adjusted returns are impossible.


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