On Randomness

  by Jesse Anderson

One of the most fundamental and most difficult concepts for investors to wrap their brain around is the randomness of markets. This is most likely because, as Terry Burnham ably shows us, in Mean Markets and Lizard Brains, humans are just not wired to deal with probability and randomness.

In the investing classic, A Random Walk Down Wall Street, Princeton Professor Dr. Burton Malkiel says:

Human nature likes order; people find it hard to accept the notion of randomness. No matter what the laws of chance might tell us, we search for patterns among random events wherever they might occur – not only in the stock market but even in interpreting sporting phenomena.

Have you ever heard a sportscaster use a phrase like hot bat, hot putter or hot hand? Those who coach, play or watch sports are almost universally convinced that a player who has made his last shot is more likely to make his next. This in spite of the studies which show these streaks are no different than that we would get given the flip of a coin.

The same is true in the stock market. Even the most casual market observer can spot trends in the stock market – periods of time where prices either rise or fall. As Nassim Taleb said in Fooled by Randomness:

Just as one day some primitive tribesman scratched his nose, saw rain falling, and developed an elaborate method of scratching his nose to bring on the much-needed rain, we link economic prosperity to some rate cut by the Federal Reserve Board or the success of a company [or country] with the appointment of the new president “at the helm.”

And likewise, in our heads, we tend to link prices to ones that came before, believing incorrectly that that which occurred in the recent past is likely to continue for the foreseeable future. If it were true, investing would be much easier. But, alas, it is not.

From A Random Walk Down Wall Street:

To a mathematician, the sequence of numbers recorded on a stock chart behaves no differently from that in the simulated stock charts – with one clear exception. There is a long-run uptrend in most averages of stock prices in line with the long-run growth of earnings and dividends. After adjusting for this trend, there is very little difference. The next move in a series of stock prices is largely unpredictable on the basis of past price behavior. No matter what wiggle or wobble the prices have made in the past, tomorrow starts out roughly fifty-fifty. The next price change is no more predictable than the flip of a coin.

For a demonstration of a random walk generator put against the returns of the stock market and the obvious similarities between the two, I encourage you to watch the first few minutes of Robert Shillers ECON 252 lecture on Behavioral Finance at Yale, which you can find in My Favorites, on my YouTube channel.

Or, for a more hands on experience, try this experiment from A Random Walk Down Wall Steet. On a piece of graph paper, construct a stock chart for a hypothetical stock by flipping a coin. On day one, the price is $50. Flip the coin to derive the closing price for each successive trading day. If the coin toss comes up heads, assume the stock goes up by $0.50. If it is tails, the stocks goes down $0.50. You will find the chart created by flipping coins will look remarkably similar to an actual stock chart and will often include many of the formations studied so intently by technical analysts – triple tops, head and shoulders formations and so forth.

For most people, this simple exercise is sufficient to prove a point I think most people secretly already suspect is true. Stock prices are random and cannot be accurately predicted by anyone, consistently, over long periods of time, outside that which we would expect given the laws of chance.

What are the implications of the randomness of stock prices for investors? Burton Malkiel sums it up this way:

The view of most investment managers [present company excepted, of course] is that professionals certainly outperform all amateur and casual investors in managing money. Much of the academic community, on the other hand, believes that professionally managed investment portfolios cannot outperform randomly selected portfolios of stocks with equivalent risk characteristics. Random walkers claim that the stock market adjusts so quickly and perfectly to new information that amateurs buying at current prices can do just as well as the pros. Thus, the value of professional investment advice is nil – at least insofar as it concerns choosing a stock portfolio.

What are the implications of the randomness of investment managers?

I believe even a cursory review of the empirical evidence makes it clear that an investment manager cannot add enough value to cover the fees he or she imposes by picking stocks or timing the market. Therefore, for an investment manager to continue taking clients money under the pretense that they can or will add some value on that basis, is misleading at best … outright thievery at worst.

For that reason, I have set out to find other ways to add real value to my clients and they are these:

1. By teaching you sound strategies for managing economic uncertainty.
2. By helping you align your financial strategies with your objectives, time horizon and tolerance for risk.
3. By creating a rigid structure for you to operate within which increases the odss you won’t make the behavioral mistakes that routinely cause you to buy high and sell low over and over again, thus keeping you from making the returns you need to meet your goals.
4. By helping you sift through what is important information and what is noise. To be successful as an investor, you have to understand the fundamentals of the game, but how much is enough and what information is important and what isn’t? I help you distinguish between a sound investment and a good sales pitch.

What are your thoughts? What else can I help you with? Feel free to email them to me. My email address is kim@kimsnider.com.

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