Message Font: Serif | Sans-Serif
No. of Recommendations: 20
Sidasbug writes: Is this luck or intelligent investing?

It's probably luck, plus risk.

If you haven't already read it, I would suggest Burton Malkiel's A Random Walk Down Wall Street. Most well-known as a popular book that trashes technical investing (charting), he also points out that fundamental analysis - basically the idea that smart people analyzing the facts can beat the market - fares no better! Securities analysts, mutual fund managers, and institutional investors all fail to beat the market in the long run. They also fail to do much simpler things like predict earnings.

Malkiel represnts the academic community, and he presents the general results of many years of academic studies:

(1) The only reliable way to alter expected returns is to adjust your amount of nondiversifiable (systemic) risk. Higher systemic risk means higher expected returns. Risk can be adjusted by holding securities that have more or less systemic risk, or by holding treasuries or investing on margin.

Academics also note, importantly, that taking specific risks that could be diversified away can't be expected to improve your returns, because if they could, big arbitragers would steal the improved returns by buying a sure-thing portfolio that diversifies away the unsystemic risk and hedges away the systemic risk. In fact, in the age of computerized trading, big arbitragers with low transaction costs spend all day trying to do exactly this kind of thing.

(2) After adjusting for systemic risk, no other strategy (fundamental analysis, technical analysis, having smart people manage your money) has been identified that beats the market consistently and widely enough to make up for transaction costs.

Of course, on the other hand, there are plenty of strategies that can reliably bump up your transaction costs - as a result, strategies that involve a lot of trading reliably lose against the market.

The academic efficiency results suggest that everybody should just passively index their money and adjust levels of cash or margin according to personal needs. Indexing diversifies away unsystemic risk (although don't forget that no index is complete, so you want to diversify over non-US and non-stock investments too) and drives down transaction costs and taxes.

The danger, of course, is that if everybody indexes their money, then nobody will be left holding the steering wheel. There is a market-efficient catastrophe waiting in the wings for us if everybody really believes the academics completely.

So I look at fundamental analysis as a game that's sort of a "civic duty." By trying our hardest to be smart and beat the market with real money, we're playing our role in keeping the market efficient. We're tugging on the steering wheel.

And maybe, just maybe, if the academics are wrong, we can even hope to beat the market whith a low level of risk. Maybe there's a chance we can identify the inefficiencies and exploit them ourselves.

But probably not. Winnings (or losses) are probably all due to luck and risk.

Print the post  


When Life Gives You Lemons
We all have had hardships and made poor decisions. The important thing is how we respond and grow. Read the story of a Fool who started from nothing, and looks to gain everything.
Contact Us
Contact Customer Service and other Fool departments here.
Work for Fools?
Winner of the Washingtonian great places to work, and Glassdoor #1 Company to Work For 2015! Have access to all of TMF's online and email products for FREE, and be paid for your contributions to TMF! Click the link and start your Fool career.