Gambling on Stocks ...what are the odds?
Dice have no memory. But how about stocks?
Early gamblers made repeated mistakes by failing to accurately assess the simplest and most obvious probabilities. Even the famous 17th century mathematician Chevalier de Mere miscalculated the odds — and lost a fortune at dice. Getting the odds wrong can be costly.
Yet, the question of how to BEGIN to calculate the odds is not an easy one. First, you must decide…is it a game of chance or of skill? That touchstone question is a good place to begin looking at the odds of making money on Wall Street. Internet era, time-challenged readers may want to skip the trouble of following my industrial age thought process. For them: a conclusion — “investors” don’t really even understand the game they are playing…let alone the odds.
The Efficient Market Hypothesis is the idea…made popular by Burton Malkiel’s Random Walk Down Wall Street…that the stock market is perfect. It always knows more than you do…since it factors in the information and thoughts of all market participants. Over the long run, therefore, you can’t hope to beat the market. This is the intellectual foundation of index funds…and it is seemingly supported by Darts vs. Pros features in the WSJ and elsewhere.
And yet, a great number of brokers’ yachts and houses in the Hamptons — not to mention the exertions of millions of individual investors — depend on the “necessary arrogance” of people who think they can, in fact, “beat the market,” Is it all a waste of time? My friend and erstwhile partner, Mark Hulbert, decided to test the Efficient Market Hypothesis.. A philosopher by training, but statistician by necessity, he’s spent the last two decades tracking the performance of investment newsletters. And guess what? Investment newsletter writers do consistently beat the market averages at about the same rate as mutual fund managers. That is…not very often…but often enough to discredit the hypothesis. Of course, random walk proponents may argue that in the very long run even the Warren Buffetts, Peter Lynchs, and best performers among the newsletter writers will regress to the mean. Maybe so. But, as Keynes pointed out…in the very long run we’re all dead. Two decades seems long enough for our purposes. Most marriages don’t last that long.
This implies that investing is more than a game of chance. There is skill involved. The average person, however, cannot be expected to have the time or training to beat the pros. Yet, that is precisely what the average stock picker tries to do. He would be better off — at least at this level of analysis — finding a mutual fund manager who consistently outperforms his sector, or a newsletter that consistently beats the market.
One DR reader complained about my comments on MSFT. Didn’t I know that Gates had bought interests in a lot of other high-tech companies? Thus, buying MSFT gives the investor not just one chance of success, but many. Hmmm…. It is certainly true that diversifying reduces risk. We know that Gates is a great business man. Maybe he’s good at running a mutual fund too. And maybe, if Moore and Metcalf really have replaced Graham and Dodd, Gates will prove to be a better fund managers than Buffett. But what are the odds of that? Besides, what you gain by diversifying you pay for in reduced performance. Among Gates’ purchases there are bound to be a lot of failures.
DR readers will also be quick to point out that until very recently, the people who bought the Dow-indexed funds substantially outperformed the fund managers. This has been a “dumb money” market — in which serious analysis was a drag on performance. A serious, professional, veteran investor would likely be cautious in the face of today’s stock prices. And that is not the way to make money in a rising market. Instead, the more fruitful approach was to throw caution to the winds and put money into the leading stocks…the ones that were already sky-high and were attracting the new money, the rank amateur, “dumb” money. Those stocks rocketed upwards while the serious analysts’ choices — the Graham & Dodd stocks that offered good value for money ….most often fell. Remember, the advance/decline line peaked out in April of 1998. Most stocks have been going down ever since. Of course, an analyst might have anticipated that the amateurs would bid up the prices of big name stocks. He might have positioned himself to benefit from this trend. But this flies in the face of most stock analysis…trying to get ahead of the dumb money seems like trying to get ahead of a runaway tractor trailer on a downhill run.
So…what how do you calculate the odds in a game of skill…when skill becomes a disadvantage…and the market is driven by investors who have no skill anyway? .
Peter Bernstein’s book, Against the Gods, has become a best-seller. It doesn’t answer this question…but it does explain a lot about how odds are calculated. What it implies about the stock market is that most buyers are not investing at all. Investing takes research, knowledge and skill. One reduces the odds of losing money by knowing something about the company one buys. There is still a lot of chance involved, but chance is tempered by knowledge. The more one knows, the less chance has to do with the results. That is why Buffett works so hard to know the companies he buys. Often, he knows them better than the people running them.
Knowledge among most investors, on the hand, is thin as Amazon’s margins. What they are doing is not investing.. They are just guessing about what might go up or down on the basis of some supposed insight into the future…or an internet tip of some sort. They might focus, for example, on the fact that China has a billion people who have never had the pleasure of attending a heavyweight wrestling spectacle.. If just one out of a hundred Chinese becomes a WWF fan, they reason, a lot of money will be made. Or, they might get a hint that a company’s earnings will be greater than anticipated. While companies release official earnings estimates, there is also a “whisper” number that circulates before the quarterly figures are announced. Stock market players guess not only about the veracity of the “whisper” but also its effect on the market. In either case, the “information” upon which they base their investment decisions is either too remote or too widely shared to give the investor an advantage. He might just as well be investing on red or black or hoping for the number 7 to come up.
Dice have no memory. Each toss cares not a fig or jibbet what happened the last toss. And yet, our intuition tells us that after rolling snake eyes ten times in a row we are less likely to do it an eleventh time. This intuition is wrong. The next throw’s odds are the same as the last. By contrast, we are very unlikely to be able to throw snake eyes 11 times in a row — which is the source of the confusion, and may require explanation.
When you have a child, you have roughly a 50/50 chance of having a girl. When you have your next child, the odds are the same. But the odds of having two girls are compounded — the 50% chance of having one girl times the 50% chance of having another one = 25%.
Gamblers in the stock market look at it in the opposite way. If the market has risen 10 years in a row…they believe it is MORE likely to rise again in the eleventh year. This intuition is false too. But here it is not even the same game. For the market is not a pair of dice. It is a giant feedback loop in which the future is constantly rerated based on what is currently happening. It is organic, evolving in unexpected ways that confound statistical expectations.. LTCM had the best quants in the world. This did not prevent them from sustaining huge losses.
In the stock market, each year is not independent of the year preceding. As a bull market draws more money into stocks it lowers the return on each dollar of stock market capital. As the process goes on, the odds of a bull market year succeeding the previous bull market year decline. Thus the life expectancy of a bull market is similar to a human life expectancy. Each normal, year a human has a certain chance of dying. But if you live to be 99…the odds of your dying that year are nearly 100%.
More on this tomorrow. It’s late. Even the loons have gone to bed.
July 27, 1999