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Risk and the Efficient Market Thesis February 2, 2009

Posted by shaferfinancial in Finance.
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Mathematicians have their talents, but one of the hidden stories from the last generation of investors is how poorly those that follow their theories (diversification, asset allocation, derivatives) have done in the market.  They created great theories, based on mathematical certainty, that failed the test of the real world.  One of those thesis is the efficient market thesis.  They have been the force behind almost every disastrous financial model coming from Wall Street.  Derivatives, corporate risk analysis, diversification, MBS’s, etc. were all designed by mathematicians working on Wall Street.  And they are at the center of what went wrong.  Critics have already pointed out the obvious,  from fat tails to black swans, that statistics failed to account for human behavior or once in a lifetime events.  But what does this have to do with the small investor.

First let’s look at the most common investment most folks make; mutual funds.  Sold as a risk free investment because of diversification, it has performed poorly almost from the beginning.  By diversification its holding of stocks a mutual fund assures itself of returns close to market returns, or so they say.  But, the facts are really different.  First, diversification skews the returns down.  Yes, it makes it unlikely that you will lose all your money, but it also makes it impossible to hit a home run.  See, my discussion on this here

But the question really is, if research points out that you get all the benefits from diversification from owning 15-20 stocks, why does the average mutual fund own over 100?  Answer is that most funds goal is size, so they want to be able to have huge funds and if they were buying heavily in one stock it would move the market up.   On the downside the opposite would occur.  So they end up buying many more stocks than necessary in order to account for their size and to be able to work under the radar.

Most mutual funds keep some of their $$ in cash for redemption purposes.  Since their are always outflows from each fund, they don’t want to have to sell stock in order to meet redemptions.  However, when the market goes down, outflows are so high that they need to sell large amounts of stock to meet their redemptions despite holding cash.  Unfortunately, many do this by selling their best performing stocks so they can book a profit.  They also sell stocks that don’t offer high dividends because those dividends help offset losses from a down market.  Finally, all mutual funds have costs, from trading, employee costs, advertising, etc. and those costs are there no matter how well or how poorly they do. 

But, perhaps the worse issue is that the diversification doesn’t account for most of the risk.  It only accounts for the risk of any particular business not doing well.  Market risk, for example, has reared its ugly head and lowered values up to 40% over the last year.  And of course, there is the risk of not getting the return needed to have enough money to retire on.  And there is market timing risk; the risk you need to use your money during a downturn in value.  So the bottom line is that mutual funds protect you against a risk you should be taking and does not protect you against risks you shouldn’t be taking.

Once again the mathematicians were wrong, because they didn’t account for human behavior.  By now most people understand the efficient market thesis is very limited in its usefulness for individuals and corporations in evaluating risks. 

So where does that leave the individual investor?  Well, first we need to be honest with ourselves.  Anytime we invest our money we should be prepared to lose it all!  Wow, is that true?  Yes, that is the psychology that is needed.  Now, beyond that we need to do things that keep us from losing all of our money on one investment and we need to learn how to invest so we don’t make poor investment decisions.  We need to forget about diversifying within asset classes unless we are actively trading stocks.  We should diversify by asset class only after we learn how to make good decisions (making a good decision does not equal making great returns; its the process which will give you long term success).  We should invest in areas that interest us or where our entrance is not blocked.

This is how I personally do it.  I invest in both real estate and stocks of companies.  I keep a good amount in reserves for the “what if” moments.  My real estate investing in done with three different strategies and my stock investing is done with the buy and hold strategy.  I also have a small account I trade with.  Now this hasn’t kept me from losing significant value over the last year, but because I am mentally prepared to lose it all, losing 20% of my portfolio value does not phase me.  Truth is I had a net worth of less than zero 10 years ago, so I figure I could do it again if needed (hope not).  Drawdowns (market losses) are the cost of doing business in the investment world and anyone who has taken that first step and become an investor has had them.

Taking calculated risks is the name of the game, and I am currently taking some of my biggest risks in my life.  If they fail, then I will start over again.  If they don’t I am that much closer to a secure retirement.  And the worst thing that can happen is that I end up like over 90% of folks dependent on the government in my old age!

Don’t let anybody tell you it can’t be done.  Those mathematicians have been saying for years that no one can beat the market, yet thousands do.  The mass media has been pointing out all the failed real estate investors and their foreclosures, yet thousands are successful in rapidly building wealth through real estate (amazingly most Realtors are not among these successful real estate investors).  Don’t let anyone tell you it is too risky, stay out of the game, because the investment game is the only one likely to get you to your retirement goals.

businessmanfinishing

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Comments»

1. Steve Diamond - February 20, 2009

Well said. Each I have to struggle with explaining the EMH to my finance and securities law students while at the same time telling them it is like applying Newton in an Einstein era.

Fortunately Benoit Mandelbrot has written a very accessible book The Misbehavior of Markets which explains the kind of world we really live in.

2. shaferfinancial - February 20, 2009

Thanks Steve,

I took a look at King Harvest. I liked it and bookmarked it. Keep up the good work!


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