Friday, July 29, 2016

A Random Walk on Wall Street

Every now and then the universe seems to be telling you something. Carl Jung believed this enough to expound on synchronicity and the collective unconscious. I don’t buy it. I suspect the universe is all random events and that any “seems” comes from confirmation bias. Be that as it may, odd coincidences do catch our attention. Several times in recent months, for example, I’ve seen references to an obscure book by successful mutual fund manager Edgar Lawrence Smith, a fellow of whom I’d never before heard – or at least I don’t remember hearing of him. (The recurrence surely has to do with my choice of reading genres in those months.) The references to the book for the most part were snickering, and that was enough to prompt me to look up the original. The author of a well-received treatise on stock investing in the 1920s, Smith in 1939 published Tides and the Affairs of Men. The title, of course, derives from Julius Caesar.

Brutus:
There is a tide in the affairs of men
Which, taken at the flood, leads on to fortune

Economic theory has gotten very mathematically complex in the past couple of decades. There is much insight inherent in the new analytical tools, and they allow for such things (among many others) as valuing arcane derivatives in ways other than guesswork. Yet, today’s economists are no better at forecasting the stock market than were their predecessors a hundred years ago. 2008 caught nearly everyone (the SEC most of all) by surprise. Accordingly, for a common investor writings from the last century are every bit as useful – and as useless – as anything new.

There are two main points in Smith’s book. One is the Decennial Cycle. Analyzing stock prices since 1880, he discerned a repeating ten year pattern in stock movements. The scale of price movement might vary but the general pattern persisted. He didn’t try to explain the pattern; he simply noted that it was there. (This pattern, if still valid, suggests 2017 will be a bad year.) The other point is weirder. He also claimed to see a correlation between stock prices and the weather. In this case I think his data points are selective to put it kindly. I would snicker if Smith hadn’t somehow managed to make money despite these views.

The fact that a fund manager could invest based on the weather and be successful at it brings to mind a point made long before Smith’s time. In 1863 Jules Regnault, who also was a successful broker/investor, wrote Calcul des Chances et Philosophie de la Bourse. In this treatise he tells us that stock prices already embody the average opinion of a multitude of investors with the result that your chances of winning or losing on any given stock pick are exactly 50:50. Prices follow a “random walk.” Actually, your odds are worse than a coin toss when you take account of transaction costs such as brokers’ fees. The only ways to make money in stocks are 1) to get lucky, 2) to have inside information, or 3) to be invested during a time of a general market price rise. (The hackneyed but useful modern phrase describing #3 is “a rising tide lifts all boats.”) Regnault preferred bonds with clearly defined rates of return over stocks, though of course one must diversify enough to survive the occasional default. That equity holdings should be diversified was centuries-old advice by 1863.

Here we have the key to Smith’s success – at least after the 1929 debacle. It didn’t really matter what wacky method he used to pick stocks so long as the general market trend was up and so long as he diversified his risks in the process.

The Random Walk is still taught in business schools as is the dartboard method of investing: throwing darts at The Wall Street Journal is as successful an investment strategy as any other. That doesn’t stop analysts from trying to beat the market. Some seem to do it, at least for a few years, but they are balanced by others who are just as smart yet lag the market. It is hard to see more than luck in either outcome.

Be warned again, though, that, if Smith was right, in 2017 there will be a change in the weather.


Barrett Strong - Money (That's What I Want) [1959]

4 comments:

  1. Yes, timing the market and predicting the future seems to be folly, but that doesn't stop headline makers. It's hard to say and it's anyone's guess. That's why one of the general rules is: Stay in the for long haul. Another rule of thumb for predicting stocks aside from the fundamentals is: Buy what you know, and buy companies whose products you use.

    Personally, I'll confess, I don't know a lot... so I generally opt for the second one. What's trending and what products do you buy daily, weekly? That doesn't always work either because some products I don't buy like a cell phone when they first came on the market or a computer or say products for women (Leggs), etc. until after the trend--I just didn't see the demand. Even so, I couldn't see that those products were in demand, trending.

    I wish I had known that when I entered the market in 2000 when computers and cell phones were taking off. Like you said the rising tide will lift all boats. Hindsight is 20 20. Here's an interesting article, again, just another headline really: No news is good news. http://www.profitconfidential.com/economic-analysis/upcoming-stock-market-crash/

    I'll have to keep 2017 in mind however.

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    1. I tried doing research and picking stocks accordingly, but the results really were no better than 50/50. Now I play darts.

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  2. Yeah it is all a gamble when it comes to stocks. I think the other viable way to win, would be to build a time machine. But if we go that route, we can't tell Doc Brown. He gets upset by that. :)

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    1. Suppose you use the time machine to go into the future where you steal from your own wallet. Then return to the past and hide your wallet where your future self can't find it. Have you made money from nothing or will the cash disappear from the future wallet even if it's locked safely away? Calling Doc Brown...

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