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.