It seems clearer and clearer to me that the financial industry is headed for an age of rocket science. An age whereby quantitative and computational finance governed by greeks, complex alogorithms and black boxes would account for an overwhelming majority of trades on exchanges. What would be the future effects of this? Would the traditional investor be disadvantaged? Is it time that all of us should have black boxes of our own?
In this post I would attempt to share my thoughts on this:
What would the future effects of this?
It means that the market will become more and more efficient in such techniques and the profit margin in relation to risks will continue to shrink. The investor will have to on an increasingly frequent basis develop new techniques and ideas, backtest it and roll it out before some hedge fund or large bank comes into the scene. The impact of this on security prices to me is unknown but I guess that prices would become much more volatile as trades become much faster than ever before. Slight changes in economic indicators can have large impact on security prices. More and more people will have to depend on leverage. Then this means there will be counter-techniques whereby institutions with large enough capital to influence prices can front-run or harvest smaller black box players by busting their stop losses or force margin calls. Volume of stocks traded would explode and this would spell well for exchanges.
Would the traditional investor be disadvantaged?
It depends, very much on the whether the investor or trader relies on similar quantitative indicators to make his trades. If he does, then he will surely be outdone by these black boxes and it would be about time he revises his investment framework. Retail investors should keep away from techniques that would pit themselves in direct competition with the big boys out there.
Is it time that we should all have black boxes of our own?
I would say no as a matter of fact. These black boxes will almost wipe out the the arbitrage business of financial securities. It requires strong foundation of financial and programming skills which is not oftenly found in any normal person. However, there is one thing that black box users do not have, that is to have a long time horizon. The quant community by and large do not like to leave themselves exposed to price fluctuations for too long. The buy and hold technique might seem outmoded and dead, but I would say it would depend very much on what you buy and at what price you bought. Blindly buying the indexes, will just allow you to do average. These quant traders would come under increasing stress and pressure to find new techniques and ideas. Whilst true buy and hold investors who have perfected the art would have no such stress.
Sunday, December 20, 2009
Debunking the Efficient Market Myth II
For several decades, there would come a time when the prevailing view that the world is so chaotic and so much beyond our control that even the most prudent of stock investments seemed foolhardy. Yet on hindsight these periods were all of opportunities that seemed almost incredible with the advantages of hindsight.
There were several times in these decades whereby some stocks will become darlings of the market. These were later to prove to be the most dangerous kind of trap for those who blindly followed the crowd than those who really knew what they were doing.
All these periods resembled the others in that they create opportunities whenever the financial community significantly misjudge the situation. The great waves of optimism and pessimism reflects the unfortuante tendency for humans to go towards extremes. Plus ca change, plus c'est la meme chose (the more things change, the more they stay the same). The idea that we have finally come into an era of prosperity or "Goldilocks" economy (remember Larry Kudlow), whereby severe booms and recessions are a relic of the past should be shelved in the memory as a "new era story".
Now I deem it to be appropriate to touch on the subject of Beta. This is a traditional academic measure of price fluctuations of common stocks against the market index. What bothers me is how the academic authorities equate Beta or price fluctuations whatsoever with the concept of risk. Price variation yes, risk no. Real investment risk is measured not by how much price will decline but the danger from the loss of quality and earning power through economic changes or deterioration in management. The idea of measuring investments via price fluctuations confuses the stock market's opinion and what actually happens to the owner's stake in the business. In the desperate search to quantify risk into a single statistical measure, academics have forgotten to evaluate the conceptual arguments of the theory. As Einstein said, "Make everything as simple as simple as possible but no simpler." This is one such oversimplification.
Beta in its purest form ignores all the qualitative characteristics of the company, what it produces, what is the nature of the business, what kind of people do they have for management. He might not even care what the company is called. What he treasures is the price history of the stock. Then if that is the case, then the concept of beta is of no difference to those who use technical analysis as both derive their validation from price fluctuations.
The true investor welcomes volatility for it means that there will be periods of time whereby irrationally low prices will be attached to outstanding businesses. He would be free to exploit its folly to his liking. What the price history of the company maybe is of no importance to him, he would prefer to further his understanding of the business. He does not seek validation from the markets and would not be disturbed even if nobody traded the stock for a year or two.
Real risk though cannot be judged or calculated with numbers, it can in some cases be judged with a level of accuracy that would be useful. A good framework would be to use Porter's Five forces in the evaluation and understand the nature of the business. Thereafter, would be judging the extent of accuracy these factors allow themselves to be predicted as well as the characteristics of management. Lastly, would be the price that the investor would pay for the business.
All these characteristics might strike an analyst as unbearably ambiguous since they do not come in some form of database by itself. In the parlance of law, this would be called the "reasonable man's test". If you were to unable to apply it with a degree of confidence that would be reassuring. Then, this would be a clear indication you are out of your circle of competence or the subject matter at hand does not render itself to such evaluations.
Obviously, every investor will make mistakes. But by confining oneself to a relatively few easy-to-understand cases, a reasonably intelligent, informed and dilligent person will be able to judge investment risks to a useful degree of accuracy.
Academics built arcane investment and capital allocation theories around price histories with correlations to create optimal portfolios. Laudable attempts but not very useful when the underlying concept is fundamentally flawed. Most of the greatest investors who have earned the highest compounded rate of returns all do not use any "optimal portoflio" of any kind. If a business is worth a dollar and one pays 40 cents for it something good may happen to him.
There were several times in these decades whereby some stocks will become darlings of the market. These were later to prove to be the most dangerous kind of trap for those who blindly followed the crowd than those who really knew what they were doing.
All these periods resembled the others in that they create opportunities whenever the financial community significantly misjudge the situation. The great waves of optimism and pessimism reflects the unfortuante tendency for humans to go towards extremes. Plus ca change, plus c'est la meme chose (the more things change, the more they stay the same). The idea that we have finally come into an era of prosperity or "Goldilocks" economy (remember Larry Kudlow), whereby severe booms and recessions are a relic of the past should be shelved in the memory as a "new era story".
Now I deem it to be appropriate to touch on the subject of Beta. This is a traditional academic measure of price fluctuations of common stocks against the market index. What bothers me is how the academic authorities equate Beta or price fluctuations whatsoever with the concept of risk. Price variation yes, risk no. Real investment risk is measured not by how much price will decline but the danger from the loss of quality and earning power through economic changes or deterioration in management. The idea of measuring investments via price fluctuations confuses the stock market's opinion and what actually happens to the owner's stake in the business. In the desperate search to quantify risk into a single statistical measure, academics have forgotten to evaluate the conceptual arguments of the theory. As Einstein said, "Make everything as simple as simple as possible but no simpler." This is one such oversimplification.
Beta in its purest form ignores all the qualitative characteristics of the company, what it produces, what is the nature of the business, what kind of people do they have for management. He might not even care what the company is called. What he treasures is the price history of the stock. Then if that is the case, then the concept of beta is of no difference to those who use technical analysis as both derive their validation from price fluctuations.
The true investor welcomes volatility for it means that there will be periods of time whereby irrationally low prices will be attached to outstanding businesses. He would be free to exploit its folly to his liking. What the price history of the company maybe is of no importance to him, he would prefer to further his understanding of the business. He does not seek validation from the markets and would not be disturbed even if nobody traded the stock for a year or two.
Real risk though cannot be judged or calculated with numbers, it can in some cases be judged with a level of accuracy that would be useful. A good framework would be to use Porter's Five forces in the evaluation and understand the nature of the business. Thereafter, would be judging the extent of accuracy these factors allow themselves to be predicted as well as the characteristics of management. Lastly, would be the price that the investor would pay for the business.
All these characteristics might strike an analyst as unbearably ambiguous since they do not come in some form of database by itself. In the parlance of law, this would be called the "reasonable man's test". If you were to unable to apply it with a degree of confidence that would be reassuring. Then, this would be a clear indication you are out of your circle of competence or the subject matter at hand does not render itself to such evaluations.
Obviously, every investor will make mistakes. But by confining oneself to a relatively few easy-to-understand cases, a reasonably intelligent, informed and dilligent person will be able to judge investment risks to a useful degree of accuracy.
Academics built arcane investment and capital allocation theories around price histories with correlations to create optimal portfolios. Laudable attempts but not very useful when the underlying concept is fundamentally flawed. Most of the greatest investors who have earned the highest compounded rate of returns all do not use any "optimal portoflio" of any kind. If a business is worth a dollar and one pays 40 cents for it something good may happen to him.
Tuesday, December 8, 2009
Debunking the efficient market myth I
Modern finance has very much based itself on a concept that I believe is quite fallacious. What I am referring to here, is the notion of market efficiency. The concept holds that in a semi-strong effcient market, the "efficient" prices are assumed to reflect fully and realistically all publicly available information. It holds that unless one gains material non-public information, there is no way of unearthing genuine bargains, since the favourable circumstances existing are already reflected in the price of the stock.
Admittedly, there is a certain element of truth in it. Very much like in a pari-mutuel betting system, the odds of a favourable gain has to be weighed against the extent of gains that is already reflected in the price. However, a half-truth doesn't serve the investor well at all.
The efficient market theory grew out of the school of random walkers. These people found out that it was difficult to identify trading strategies that worked well enough after transaction costs over along periods of time relative to the risks undertaken. These trading strategies work well some of the time and fail in others. It becomes very much like flipping a coin to decide whether to buy a stock. I don't disagree with this.
Once again, I set out disqualifiers, because there are always exceptions to the rule but not many. These include high frequnecy alogorithm traders such as Renaissance Technologies and other quantitative funds. This method is gaining alot of attention and competition from large banks and hedge funds. I believe it would become a matter of time before the market starts to arbitrage away these huge profits.
Though I know quite a bit about program trading, I do not know enough to give advices. What I am proposing here is the best method of investing not trading. One should be seeking investment opportunities with unusual prospects over the long term and avoid those that are of poor quality. This would be the central tenet to the proposal that is prescribed here.
I do not believe the markets are efficient in this approach because it is unpopular and many investors have a tendency to learn the wrong lessons. At first glance, it might seem amateurish, inexperienced and sometimes downright dumb to the untrained eye. It is safe to say to assume if you knew something was wrong, you wouldn't believe it in the first place.
Most humans, hate self-questioning and prefer to spend their time convincing themselves and others their beliefs are right. These beliefs persist, particularly when they make sense intuitively and even more so when others around agree to it. To determine the efficiency or the lack of thereof with the investment approach, the investor will have to look at whether approach are scientifically sound and relatively unpopular. The method must not be generally accepted because those that are well accepted do not produce the required results. Ironically, this reflects an unfathomable idea, "Precisely because nobody ever think is going to work, which is why it is going to work wonders."
Be particularly wary of making a decision simply because of something you know others agree with. The reasons why we hold certain false belief is because 1) They make common sense and one is typically not prone to question his common sense. 2) People around you tend to agree with you and one do not have an inclination to challenge widely held views.
By and large, those who have accepted and been influenced by the efficient market theory fall in into 2 groups. One is students, who have had a minimum exposure to practical experience. The otherm strangely enoughm is those managers of large institutional funds. The private investor by and large has paid relatively little attention to this theory.
Also, a large number of studies have shown that variation in portfolio values are 90% caused by asset allocation between the different asset classes. Implying that the greatest gains or losses are to be made by moving in and out of markets. However, it is of my viewpoint that timing the market is extremely diffiicult, simply because you have to get several things right. One will have to select the right stocks, to make sure it can withstand a severe crisis. You have to make sure that the price is right and you are not catching a falling knife. You also will have to get out at a good price with the timing right the next time you sell out.
What I am proposing here, is to choose extremely carefully the stocks you are going to buy. Buy them at a relatively fair price. Then put your hands under your butt for the next few decades, a "buy and sit on your butt" approach to investing. Then you just wait. That is all to it.
It can be easily observed that in a portfolio of a large number of stocks, be it a mutual fund or an index. Countless empirical evidences show that a "small" number of stocks actually drives a large proportion of changes of value within any portfolio. Over a couple of decades, these gains in value can become extremely substantial. The ultimate question then begets "Is it possible for investors to identify them?" My answer is "Yes, you can. However, it is not easy to find such opportunites at all."
Admittedly, there is a certain element of truth in it. Very much like in a pari-mutuel betting system, the odds of a favourable gain has to be weighed against the extent of gains that is already reflected in the price. However, a half-truth doesn't serve the investor well at all.
The efficient market theory grew out of the school of random walkers. These people found out that it was difficult to identify trading strategies that worked well enough after transaction costs over along periods of time relative to the risks undertaken. These trading strategies work well some of the time and fail in others. It becomes very much like flipping a coin to decide whether to buy a stock. I don't disagree with this.
Once again, I set out disqualifiers, because there are always exceptions to the rule but not many. These include high frequnecy alogorithm traders such as Renaissance Technologies and other quantitative funds. This method is gaining alot of attention and competition from large banks and hedge funds. I believe it would become a matter of time before the market starts to arbitrage away these huge profits.
Though I know quite a bit about program trading, I do not know enough to give advices. What I am proposing here is the best method of investing not trading. One should be seeking investment opportunities with unusual prospects over the long term and avoid those that are of poor quality. This would be the central tenet to the proposal that is prescribed here.
I do not believe the markets are efficient in this approach because it is unpopular and many investors have a tendency to learn the wrong lessons. At first glance, it might seem amateurish, inexperienced and sometimes downright dumb to the untrained eye. It is safe to say to assume if you knew something was wrong, you wouldn't believe it in the first place.
Most humans, hate self-questioning and prefer to spend their time convincing themselves and others their beliefs are right. These beliefs persist, particularly when they make sense intuitively and even more so when others around agree to it. To determine the efficiency or the lack of thereof with the investment approach, the investor will have to look at whether approach are scientifically sound and relatively unpopular. The method must not be generally accepted because those that are well accepted do not produce the required results. Ironically, this reflects an unfathomable idea, "Precisely because nobody ever think is going to work, which is why it is going to work wonders."
Be particularly wary of making a decision simply because of something you know others agree with. The reasons why we hold certain false belief is because 1) They make common sense and one is typically not prone to question his common sense. 2) People around you tend to agree with you and one do not have an inclination to challenge widely held views.
By and large, those who have accepted and been influenced by the efficient market theory fall in into 2 groups. One is students, who have had a minimum exposure to practical experience. The otherm strangely enoughm is those managers of large institutional funds. The private investor by and large has paid relatively little attention to this theory.
Also, a large number of studies have shown that variation in portfolio values are 90% caused by asset allocation between the different asset classes. Implying that the greatest gains or losses are to be made by moving in and out of markets. However, it is of my viewpoint that timing the market is extremely diffiicult, simply because you have to get several things right. One will have to select the right stocks, to make sure it can withstand a severe crisis. You have to make sure that the price is right and you are not catching a falling knife. You also will have to get out at a good price with the timing right the next time you sell out.
What I am proposing here, is to choose extremely carefully the stocks you are going to buy. Buy them at a relatively fair price. Then put your hands under your butt for the next few decades, a "buy and sit on your butt" approach to investing. Then you just wait. That is all to it.
It can be easily observed that in a portfolio of a large number of stocks, be it a mutual fund or an index. Countless empirical evidences show that a "small" number of stocks actually drives a large proportion of changes of value within any portfolio. Over a couple of decades, these gains in value can become extremely substantial. The ultimate question then begets "Is it possible for investors to identify them?" My answer is "Yes, you can. However, it is not easy to find such opportunites at all."
The death of one man is a tragedy, the death of millions is a statistic
Just finished the first level of CFA exams. The questions and concepts per se are not really that difficult. What is harder is finding the time and discipline to study as well as the stamina of going through 6 hours of nerve-wrecking challenge. Whatever happens next, be it good or bad, life still goes on.
I have learnt to adopt a more philosophical attitude towards success and failure. Even if one fails, life still goes on, just pick up the pieces learn from your mistakes and move on. Disasters strike, tragedies happen almost on a daily basis to different people in different parts of the world. One is neither unique nor alone. It maybe harsh but I never gave myself (sometimes even others) much sympathy or excuses to wallow in past failures.
The corporate world has a terminology for the end result of such instances. It is commonly known as BAU (Business As Usual). No matter what happened yesterday, the world continues to revolve, markets continues to open, businesses need to be made and jobs still need to be done. Sometimes, I wonder to myself since when did I ever become such a cold-blooded creature.
After some thought, I could trace the rationalization back to an event couple of years ago. It was the day of Tsunami on 2004, whereby almost 300,000 people killed with the highest number of casualties coming from Indonesia. From a perspective of a normal human being, it was an unprecedented disaster. However, what surprised me even more, was that the JKSE index unflinchingly rose instead, marching unstoppably forward. That very moment, impounded within me a icy-chilling sense of reality that till today still continue to send shivers down my spine.
Compare and contrast this with the events of the September 11 tragedy, whereby 3000 people died and stock markets worldwide fell sharply. Though both are tragic events, but the relative costs in terms of human lives couldn't be more apparent. One is a hundred times more than the other and yet responses by markets couldn't be more inconsistent.
Capitalism has implicitly placed a price on human lives. What the markets are telling us, despite how unsightly it is, is that the world can't be bothered by people whose lives don't matter. As the saying goes, the death of one man is a tragedy, the death of millions is a statistic. It seems Joseph Stalin knows a little more about human nature than we do.
I have learnt to adopt a more philosophical attitude towards success and failure. Even if one fails, life still goes on, just pick up the pieces learn from your mistakes and move on. Disasters strike, tragedies happen almost on a daily basis to different people in different parts of the world. One is neither unique nor alone. It maybe harsh but I never gave myself (sometimes even others) much sympathy or excuses to wallow in past failures.
The corporate world has a terminology for the end result of such instances. It is commonly known as BAU (Business As Usual). No matter what happened yesterday, the world continues to revolve, markets continues to open, businesses need to be made and jobs still need to be done. Sometimes, I wonder to myself since when did I ever become such a cold-blooded creature.
After some thought, I could trace the rationalization back to an event couple of years ago. It was the day of Tsunami on 2004, whereby almost 300,000 people killed with the highest number of casualties coming from Indonesia. From a perspective of a normal human being, it was an unprecedented disaster. However, what surprised me even more, was that the JKSE index unflinchingly rose instead, marching unstoppably forward. That very moment, impounded within me a icy-chilling sense of reality that till today still continue to send shivers down my spine.
Compare and contrast this with the events of the September 11 tragedy, whereby 3000 people died and stock markets worldwide fell sharply. Though both are tragic events, but the relative costs in terms of human lives couldn't be more apparent. One is a hundred times more than the other and yet responses by markets couldn't be more inconsistent.
Capitalism has implicitly placed a price on human lives. What the markets are telling us, despite how unsightly it is, is that the world can't be bothered by people whose lives don't matter. As the saying goes, the death of one man is a tragedy, the death of millions is a statistic. It seems Joseph Stalin knows a little more about human nature than we do.
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