Justin Fox’s The Myth of the Rational Market: A History of Risk, Reward, and Delusion on Wall Street(Harriman House, 2009) isn’t exactly hot off the press, but I discovered it only recently. It’s a fast-paced history, replete with interesting (sometimes chatty/catty) details, of theories about the financial markets from Irving Fisher to Robert Shiller.
The cast of characters is huge. I list them here to give a sense of the scope of the just shy of 400-page book: Kenneth Arrow, Roger Babson, Louis Bachelier, Fischer Black, John Bogle, Warren Buffett, Alfred Cowles III, Eugene Fama, Irving Fisher, Milton Friedman, William Peter Hamilton, Friedrich Hayek, Benjamin Graham, Alan Greenspan, Michael Jensen, Daniel Kahneman, John Maynard Keynes, Hayne Leland, Robert Lucas, Frederick Macaulay, Burton Malkiel, Benoit Mandelbrot, Harry Markowitz, Jacob Marschak, Robert Merton, Merton Miller, Wesley Mitchell, Franco Modigliani, Oskar Morgenstern, M.F.M. Osborne, Harry Roberts, Richard Roll, Barr Rosenberg, Stephen Ross, Mark Rubinstein, Paul Samuelson, Leonard “Jimmy” Savage, Myron Scholes, William F. Sharpe, Robert Shiller, Andrei Shleifer, Herbert Simon, Joseph Stiglitz, Lawrence Summers, Richard Thaler, Edward Thorp, Jack Treynor, Amos Tversky, John von Neumann, and Holbrook Working. (more…)
Archives of “efficient market hypothesis” tag
rssA Useful Stock Market Dictionary
I just finished reading Jason Zweig’s new book “The Devil’s Financial Dictionary” and boy is it good. If you’ve ever been overwhelmed by all the jargon used in finance and economics then this is right up your alley. Jason offers up a witty, brilliant and most importantly, useful collection of honest definitions. It’s a collection of all the things most people think about these words, but are too afraid to actually say. For instance:
ACCOUNT STATEMENT, n. A Document from a bank, brokerage, or investment firm that is designed to be incomprehensible to the CLIENTS, thereby preventing them from asking impertinent questions like “Who set my money on fire?” You might be able to recognize your balances and recent transactions on an account statement, although that will be easier if you earn a PhD in cryptography first.
EFFICIENT MARKET HYPOTHESIS, n. A theory in financial economics believed only by financial economists. In theory, the market price is the best estimate at any time of what securities are worth; it immediately incorporates all the relevant information available, as rational investors dynamically update their expectations to adjust to the latest events. In practice, however, investors either ignore new information or wildly overreact to it, regardless of how relevant it is. Even so, that doesn’t make beating the market easy, because you must still outsmart tens of millions of other investors without incurring excess trading costs and taxes. As behavioral economists Meir Statman puts it, “The market may be crazy, but that doesn’t make you a psychiatrist.”
FEE, n. A tiny word with a teeny sound, which nevertheless is the single biggest determinant of success or failure for most investors.
Investors who keep fees as low as possible will, on average, earn the highest possible returns. The opposite may be true for their financial advisors, although that is still not widely understood.
Hank Pruden on "Behavioral Finance" and Technical Analysis
Hank Pruden’s theory of “Behavioral Finance” proposes that human flaws are consistent, measurable and predictable, and being aware of and utilizing this phenomenon can benefit a trader.
“For the better part of 30 years, the discipline of finance has been under the thrall of the random walk\cum efficient market hypothesis. Yet enough anomalies piled up in recent years to crack the dominance of the random walk. As a consequence, the popular press has been reporting the market behavior,” said Pruden. One of these new methods discussed is “behavioral finance.”
Pruden is a professor in the School of Business at Golden Gate University in San Francisco. He was a featured speaker at the 20th annual Telerate Seminars Technical Analysis Group Conference (TAG 20). (more…)
30 One Liner For Traders -Must Read
1. Buying a weak stock is like betting on a slow horse. It is retarded.
2. Stocks are only cheap if they are going higher after you buy them
3. Never trust a person more than the market. People lie, the market does not.
4. Controlling losers is a must; let your winners run out of control.
5. Simplicity in trading demonstrates wisdom. Complexity is the sign of inexperience.
6. Have loyalty to your family, your dog, your team. Have no loyalty to your stocks.
7. Emotional traders want to give the disciplined their money.
8. Trends have counter trends to shake the weak hands out of the market
. 9. The market is usually efficient and can not be beat. Exploit inefficiencies.
10. To beat the market, you must have an edge. (more…)
The Secrets of The World’s Greatest Traders
Traders and investors have made and lost some of the world’s most significant pools of wealth. It’s no coincidence that many of the wealthiest individuals in the world today (and through history) have been successful investors. Names like Warren Buffet, George Soros, John Paulson, David Einhorn, Bill Gross and Sir John Templeton have become synonymous with strategies that have created astonishing success, in many case creating a groundswell of books and analysts who study their lives with a toothcomb to understand “what” the magic formula was…
Even outside these heavyweights of the trading world, hundreds of thousands of individuals around the world attest to have ‘the best‘ strategy to generate consistent positive returns (in fact, Google alone reveals over 10.4 million results when searching for best trading strategies). At a macro-level, the long-standing efficient market hypothesiswould make it notionally impossible for any trading strategy to be effective (as it asserts a level of information efficiency in the market). The past quarter century however, has seen a gradual move away from the efficient hypothesis to greater considerations of information asymmetry and behavioral biases driving inefficiencies (opportunities) in the market. So faced with this complexity, how do some traders generate such astonishing success?
To learn more, I spoke with Jack Schwager who is perhaps best known for his “Market Wizards” book series in which he has interviewed a cross section of the most successful traders and investors in the world. In May 2012 Jack released the latest book in this best-selling series, “Hedge Fund Market Wizards” (a behind-the-scenes look at the world of hedge funds, from fifteen traders who’ve consistently beaten the markets).
Jack Schwager is a recognized industry expert in futures and hedge funds and the author of a number of widely acclaimed financial books. He is currently the co-portfolio manager for the ADM Investor Services Diversified Strategies Fund, a portfolio of futures and FX managed accounts. He is also an advisor to Marketopper, an India-based quantitative trading firm, supervising a major project that will adapt their trading technology to trade a global futures portfolio. Previously, Mr. Schwager was a partner in the Fortune Group, a London-based hedge fund advisory firm, which specialized in creating customized hedge fund portfolios for institutional clients. His previous experience includes 22 years as Director of Futures research for some of Wall Street’s leading firms and ten years as the co-principal of a CTA.
Q: Is there a strategy or style which is most effective at generating return?
[Jack Schwager] The diversity of strategies people use is truly remarkable, I saw people using completely different strategies to the degree that if I had set out to invent 15 different strategies for a fictional work…. I couldn’t have made the strategies more different to the ones I saw in real life! This illustrates a point I have made in all my works insofar as there really is no ‘holy grail‘ or single style that is most effective. Those people looking for a single unified strategy are not asking the right question.
It’s a matter of finding an approach that works for the individual. A person has to know whether they are comfortable with fundamental or technical, long term or short term, certain types of markets, wider risk or less risk… You can go through a whole checklist of things and find it’s different for each individual.
Even when looking at differences between asset classes we see that every market can be traded using different strategies be they fundamental, technical, or a mixture. If we take equity markets we see that traders can use strategies including fundamental, value, extreme long term, and day. If you want a microcosm that proves diversity, there it is! (more…)
$25 Billion Hedge Fund Manager Explains 'How To Be A Great Trader'
Some perspective on ‘efficient markets’ from Elliott Management’s Paul Singer,
The fact that the vast majority of investors and traders cannot (with rare exceptions) beat the markets over long periods of time is not an argument for efficiency.Rather, the reason is that they are mostly doing the same thing sharing the same set of assumptions, and following the same impulses.
The fact that a basic assumption about the world is widely held does not make it true, nor does it make trading and pricing decisions based on that assumption efficient regardless of how liquid markets pricing in that assumption appear to be!
Certainly there are periods of time when some markets and submarkets appear to be efficient, but those who have vision, creativity and an understanding of the broader context of markets will make greater returns and/or attain a superior risk profile (assuming they do not get run over by standing rigidly against the sometimes-deeply false passions of the day expressed by the consensus).
How do the select few more or less continuously make money when the “efficient” markets are moving all over the place? Why do most investors fail, over long periods of time, to keep up with their desired index? And why do some people blow up? (more…)
Weatherall, The Physics of Wall Street-Book Review
James Owen Weatherall’s The Physics of Wall Street: A Brief History of Predicting the Unpredictable (Houghton Mifflin Harcourt, 2013) is an engrossing book. Even though I was familiar with many of the stories the author recounts, at no point was I tempted to skip a page. Coming from me, that’s high praise indeed.
In the first chapter Weatherall takes the reader on a journey from sixteenth- and seventeenth-century attempts at a systematic theory of probability (Cardano, de Méré, Pascal, and Fermat) through Bachelier’s 1900 dissertation, A Theory of Speculation. Bachelier is credited with having come up with the random walk model/efficient market hypothesis. Like many quants, he was ahead of his time. “In a just world, Bachelier would be to finance what Newton is to physics. But Bachelier’s life was a shambles, in large part because academia couldn’t countenance so original a thinker.” (p. 27)
It wasn’t until Maury Osborne’s 1959 paper entitled “Brownian Motion in the Stock Market,” similar in both topic (predicting stock prices) and solution to Bachelier’s thesis, that people began to understand that physics could make a substantial contribution to finance. By then, as Osborne said, “Physicists essentially could do no wrong.” (p. 28) Scientists were in demand in industry, research facilities, and government. Pre-The Graduate, think nylon and the Manhattan Project.
Osborne found that stock prices don’t follow a normal distribution as Bachelier had suggested; rather, the rate of return on a stock (the “average percentage by which the price changes each instant”) is normally distributed. “Since price and rate of return are related by a logarithm, Osborne’s model implies that prices should be log-normally distributed.” (more…)
Jesse Livermore Quotes -Must Read & Follow
1) The stock market is never obvious. It is designed to fool most of the people, most of the time.
2) Play the market only when all factors are in your favor. No person can play the market all the time and win.There are times when you should be completely out of the market, for emotional as well as economic reasons.
3) Do not use the words “Bullish” or “Bearish.” These words fix a firm market-direction in the mind for an extended period of time. Instead, use “Upward Trend” and “Downward Trend” when asked the direction you think the market is headed. Simply say: “The line of least resistance is either upward or downward at this time.”Remember, don’t fight the tape!
4) The game of speculation is the most uniformly fascinating game in the world. But it is not a game for the stupid, the mentally lazy, the person of inferior emotional balance, or the get-rich-quick adventurer. They will die poor.
5) The only thing to do when a person is wrong is to be right, by ceasing to be wrong. Cut your losses quickly, without hesitation. Don’t waste time. When a stock moves below a mental-stop, sell it immediately. (more…)
5 Trading Lessons-Must Read
- Most of the time, markets are very close to efficient (in the academic sense of the word.) This means that most of the time, price movement is random and we have no reason, from a technical perspective, to be involved in those markets.
- There are, however, repeatable patterns in prices. This is the good news; it means we can make money using technical tools to trade.
- The biases and statistical edges provided by these patterns are very, very small. This is the bad news; it means that it is exceedingly difficult to make money trading. We must be able to identify those points where markets are something a little “less than random” and where there might be a statistical edge present, and then put on trades in very competitive markets.
- Technical trading is nothing more than a statistical game. The parallels to gambling and other games of chance are very, very close. A technical trader simply identifies the patterns where an edge might be present, takes the correct position at the correct time, and manages the risk in the trade. This is, of course, a very simplified summary of the trading process, but it is useful to see things from this perspective. This is the essence of trading: find the pattern, put on the trade, manage the risk, and take profits.
- Because all we are doing is playing the small edges as they occur in the markets, it is important to be utterly consistent in every aspect of our trading. Many markets have gotten harder (i.e. more efficient, more of the time) over the past decade and things that once worked no longer work. Iron discipline is a key component of successful trading. If you are not disciplined every time, every moment of your interaction with the market, do not say you are disciplined.
3 Hard Questions
Markets are highly random and are very, very close to being efficient.
If you are a new trader, trading is probably harder than you think it can be. If you’ve been trading a while, you know this. Financial markets are one of the most competitive environments in the modern world. New information is quickly processed and incorporated into prices. This means that you cannot outsmart the market consistently. You cannot invest based on what you think makes sense or should happen because you are up against investors with superior access to information, knowledge, experience, capital and other resources. Most of the time, markets move in a more or less random fashion; you can’t make money if market movements are random. (“Efficient”, in this context, is an academic term that basically means that all available information is reflected in prices.)
It is impossible to make money trading without an edge.
There are many ways to create an edge in the markets, but one this is true—it is very, very hard to do so. Most things that people say work in the market do not actually work. Treat claims of success and performance with healthy skepticism. I can tell you, based on my experience of nearly twenty years as a trader, most people who say they are making substantial profits are not. This is a very hard business.
Every edge we have is driven by an imbalance of buying and selling pressure.
The world divides into two large groups of traders and investors: fundamental traders who base decisions off of financial analysis, understanding of the industry and a company’s competitive position, growth rates, assessment of management, etc. Technical traders base decisions off of patterns in prices, volume or related data. From a technical perspective, every edge we have is generated by a disagreement between buyers and sellers. When they are in balance (equilibrium), market movements are random.