Thinking About Money

You’ve heard of the Efficient Markets Hypothesis, and Behavioral Finance. Yet neither completely satisfy. Today, I’m pleased to introduce a new theory that may well truly explain market behavior.

Have you ever noticed that changes in stock prices often have nothing to do with anything? That good news can result in huge sell-offs? This started me thinking….

There is an interesting presumption in our society regarding investing that is reflected in the following question (that I’ve heard often): “What makes you think you’re smarter than professional investors? What makes you think you can do better?”

At the same time, there are serious investors such as Peter Lynch, the folks at Motley Fool, etc. who say yes – an individual investor can do better than the market. They propose a number of reasons – that we can invest in smaller companies than the large funds (thus invest in companies before the big guys notice them), that we are less susceptible to influence by the relatively small number of large fund managers, and so on. Yet even they barely challenge the underlying assumption that the Wall Street experts are highly trained, intelligent, and skilled at accurately and efficiently evaluating investments.

Today I’d like to dig deeper and propose a theory of how markets really work. Let me stress, this is just a preliminary theory – I still have to put some thought into how to test for it.

As with any theory, we need to set up our basic premises.

The players:

Market prices are determined by the actions of three distinct groups: individual investors, fund managers (both mutual fund and intstitutional), and aggressive traders (hedge funds). There is some overlap between these groups. For example: some individual investors and investors are traders (sophisticated in this sense means using strategies other than simple long investments and trading frequently).

The prices:

Rapid moves in stock prices are purely a result of the actions of aggressive traders. Medium and long term investors do panic or get enthusiastic about stocks, but they don’t respond as quickly as those who are watching the minute by minute fluctuations of a stock. Individual investors can only move stocks when acting in large numbers and most don’t pay close enough attention to make much of a difference.

Cause and Effect:

When you read market news, you will almost always find a reason for why a stock did what it did. Sometimes the reasons are hard to swallow- for example: recent declines in stock prices of fast food companies have been attributed to high gas prices causing people to not want to drive to a restaurant. This, despite the fact that there is little evidence yet that people really are driving less, that fast food restaurants are rarely far from anyone, and that eating out is often combined with other errands.

What you will rarely read is an analyst saying “we have no idea why the stock moved the way it did.” In fact, I don’t recall ever seeing that kind of statement. It’s always: the market moved up on declining interest rates, or down on higher oil prices, etc.

These statements give the illusion that the market moves for a reason. The Stupid Markets Theory proposes that most explanations of why stock or market prices change in the short term are rationalizations after the fact, and do not reflect an actual cause.

The Power of Stupidity

Read your daily paper. Watch the Daily Show. Have you noticed that it’s very easy to find stories of extraordinary stupidity? Just look at the actions and statements of many politicians. Look at some of the laws that are passed quickly, with little thought and far-reaching unintended consequences.

Why on earth would we imagine that this same level of stupidity would not also apply to pricing of stocks and the behavior of the market?

Once upon a time, information on companies was hard to come by and insider trading and information was much more common, making it relatively easy for professional investors to take advantage of their knowledge to achieve extraordinary gains. The widespread availability of information and improved disclosure has reduced this advantage. There are still ways for people to take advantage – inside information still exists, as does corruption and deceit, and market manipulation by traders. Nevertheless, the situation has improved considerably.

The efficient market theory suggests that it is impossible to beat the market because everyone has much the same information. Some will overreact one way, some the other, but overall shares will be efficiently priced.

But the efficient market theory underestimates the power of human stupidity. We see what we want to see. We are much more comfortable following a trend than leading one. The behavioral market theories reflect this in part, but even they do not go far enough in considering a key fact: we are just plain stupid.

The Theory Stated

The Stupid Market Theory has the following principles:

• A share of stock represents ownership in a company. It’s price is determined by the market, but it’s value is based on the value of the company. In the long term, the price of a stock will have a relationship to the value of the stock.
• Most short term movement of a stock is a result of the decisions of a relatively few traders who are either reacting to information based on their own biases, acting illegally on inside information, or intentionally manipulating the stock. As such, a significant amount of this movement will be fundementally stupid.
• Most explanations for short term movement of a stock or the market are rationalizations – attempts to add reason to the inexplicable. As such, they are stupid and should be ignored. Paying attention to daily financial news is a waste of time and is far more likely to increase your own level of stupidity than to help you predict others stupid behavior.

The Stupid Market Theory is fully compatible with value investing. It offers and explanation of why value investing works. Day trading and mathematical systems that attempt to time the market may work at times, but because they are ultimately trying to predict human stupidity (and humans have an infinite ability to do an infinite variety of stupid things), they are unlikely to achieve long term success. Looking at it another way: if 50% of your decisions are stupid, and 50% of daily stock pricing is determined by stupidity, your chances of correctly predicting rational stock movements with a perfect system are maybe 25%. With the typical (imperfect) system, your chances are even less. The rest of your results would be determined by luck.

The Stupid Market Theory may dismiss technical investing, but it challenges value investing as well. Value investing requires an ability to analyze not just the financials and prospects of a company, but also it’s underlying story. For the latter, information is often incomplete, and even when available, is easy to misinterpret. In other words: where technical investing matches your stupidty against the stupidity of everyone else (aka, the mob of investers or “Mr. Market”), value investing matches your stupidity against yet another group of individuals: corporate managers.

Conclusion (for now):

The Stupid Market Theory does not, itself, offer a miraculous new trading strategy. Rather, it offers a different way of viewing investing – one that is perhaps overly optimistic, but is worth considering. Specifically, rather than viewing the individual invester as a poor sucker with no chance of beating the market, it suggests that an individual can do dramatically better than the market, should he or she find a way to act less stupidly than everyone else. Clearly a few select great investors have managed to do so (or were very lucky – in the total universe of investors surely some will succeed on sheer chance alone). How this might translate into practice has yet to be determined, as is the truth of the theory. Yet who can deny that funds and individuals alike have invested stupidly, and done so often? The fact that most mutual funds fail to even match the returns of the market overall is strong evidence on this score. Given this fact, the idea that stupidity might be the overriding force behind market prices (at least in the short term), is not as insane (dare I say, stupid) an idea as it might sound.

For more on this, watch next week for “The Stupid Manager Theory”

This entry was posted on Saturday, July 29th, 2006 at 12:17 pm and is filed under General, Investing. You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response, or trackback from your own site.