On the Path to Profits? Don’t Get Lost!
There are lots of theories about stock market prices. My favorite is the “random walk hypothesis.” The idea behind random walk is that the stock market is efficient. The price of a stock reflects everything that’s known about the stock. Thus, at any given moment, the price of a stock is always “correct.” New information about that stock will be randomly good or bad. Therefore, the price of a stock will go up and down randomly. You can’t beat the market!
If the random walk hypothesis were true it would put everybody at American Consequences (plus you, our readers) out of business. But don’t worry, it isn’t. The reason I like the random walk hypothesis is because it’s funny and I’m a humorist.
First there’s the notion that the stock market is “efficient.” Yes, free markets are a more efficient way to allocate capital than, for example, government spending. But feeding money into a wood chipper is also more efficient than government spending.
The dictionary definition of “efficient” is “producing a desired effect with a minimum of effort, expense, or waste.”
The P.J.’s-many-years-of-life-experience definition of “efficient” is “good luck with that.”
As far as I can tell, nothing in the world is “efficient” – not work, marriage, children, cars, home, household appliances – let alone 401(k)s.
Not even my bird dog produces a desired effect with a minimum of effort, expense, or waste. The desired effect is dead pheasants. I’ve been training my bird dog for years. What she hunts for is porcupines. The vet bills are through the roof. And she just pooped on the kitchen floor.
A stock price may have just done the same – because of an inefficiency in the market. Better get in there and clean up!
Then there’s the proposition that future news about a given stock will be “randomly” good or bad. News may be unpredictable but it’s hardly random. When I get a 2 a.m. phone call from my teenage daughter, I may not be able to predict the bad news but I know it’s going to be bad news.
On the other hand, when I see Ed McMahon and the Publishers Clearing House crew coming up my driveway…
That’s good news for antipsychotic drug manufacturers. I should invest in them immediately because Ed McMahon is dead.
Random walk is an example of the strange relationship that mathematics can have to reality – in this case, the reality of investing.
The term “random walk” was coined by mathematician Karl Pearson (1857-1936), father of the modern discipline of statistics.
And cursed be Pearson’s name by all business majors who’ve been frog-marched through required statistics courses. Saying that a good grade in statistics is necessary for business success would make Ray Kroc (to give one instance of someone who never went to business school) flip burgers in his grave.
Pearson’s “random walk” referred to the outcome of a mathematical formula producing results that are completely random. It is surprisingly difficult to get completely random results from mathematical formulas, just as it is surprisingly easy to get completely random results from formulas for life. The stock market is much more predictable than life – as anyone, except a mathematician, can tell you.
(Karl Pearson, that SOB, also invented the mind-numbing standard deviation. I once asked the famed sociologist, political theorist, and statistician, Charles Murray why social scientists used the standard deviation. The standard deviation is “the square root of the variance in a data set.” The variance is how far the numbers in the data set are spread out from their average. “Why not just show us the numbers?” I said to Charles. “Why use a standard deviation?” Charles did not have a ready answer. He said, “Because it makes a prettier curve?”)
A jollier term for random walk is “drunken walk,” and all business majors who’ve managed to pass statistics should treat themselves to one.
The random walk hypothesis was popularized by Princeton economics professor Burton Malkiel. He and his students created an imaginary stock with a price of $54. Then the students tossed a coin. Heads, the stock went up a dollar. Tails, the stock went down a dollar. They did this 90 times and thus created a fictional three-month chart for the imaginary stock. (As you’d guess, the price ended up pretty close to $54.)
Professor Malkiel took the chart to a Wall Street technical analyst who, as technical analysts do, attempted to predict future movements of the stock based on past performance. Due, no doubt, to a longish run of “heads” toward the end of the experiment, the technical analyst recommended a buy.
Prof. Malkiel and his students had a good laugh. In 1973 Malkiel published his book, A Random Walk Down Wall Street. It has sold 1.5 million copies and is still in print.
But there’s one thing that Professor Malkiel and his students didn’t pay any attention to. They were lying. The chart they gave to the technical analyst was alleged to contain information. It contained none.
Given the shape of the graph, of course the analyst said “buy.” What if I called my money manager and said, “My son built a cold-fusion reactor for his eighth-grade science project. It seems to work pretty well. MIT has offered him a full scholarship and wants him to enroll right away even though he’s only 14. Should I spring for his $75 round-trip bus fare to Boston so he can give the campus a look?” I believe my money manager would tell me to buy the Trailways ticket.
If Malkiel had turned the graph upside down, the analyst would have said “sell.”
Good investment research and analysis exist to protect us from Burton Malkiel and his students at Princeton.
Sorry, Burton. It’s not as if you don’t have a point. There is truth in the random walk hypothesis – if you’re taking a random walk.
If you’re wandering around with no idea where you’re going or, for that matter, where you are – that is, if you’re a completely ignorant investor – then you are better off in an index fund.
It’s either that or use the full power of your complete ignorance to guide your investment decisions. In which case you’ll want to buy General Electric shares because they’re so darn cheap and because, after all, mom’s old avocado green 1970s top-loading GE washer is still chugging away in the basement. Then I suggest a long random walk on a short random pier.