Is The Market Rational?

This article ran in Fortune in 2002. If you never read it before, you should. If you have read it, it’s worth your time to read it again. It’s written by Justin Fox. He went to the University of Chicago to talk to Efficient Markets guru Eugene Fama and behavioral economist Richard Thaler. You can read the exchange below. Also, from this article, Justin wrote a recently published book that you should read. It’s called The Myth of the Rational Market: A History of Risk, Reward, and Delusion on Wall Street

Is The Market Rational? No, say the experts. But neither are you–so don’t go thinking you can outsmart it.
By Justin Fox
December 9, 2002

Buy and hold. Diversify. Put your money in index funds. Pay attention to the one thing you can control–costs–and keep them as low as possible. Today that is pretty standard, if often unheeded, investment advice. Forty years ago it was revolutionary. The revolution started on college campuses, in particular at the University of Chicago, and it went by the unrevolutionary-sounding name “efficient markets.”

“In an efficient market,” wrote Chicago professor Eugene Fama in a landmark paper he delivered at the 1969 annual meeting of the American Finance Association, “prices ‘fully reflect’ available information.” That is, in an efficient market you can’t beat the market unless you have inside information. So why bother trying?

That logic led, among other things, to the creation of index funds that aim to mimic, not beat, the likes of the S&P 500 and the Wilshire 5000. Today such funds account for about 10% of total U.S. stock market capitalization, as well as 60% of what little money has flowed into equity mutual funds so far this year. But millions of small investors have continued to ignore the advice derived from efficient-markets theory, preferring instead to trade stocks and pile in and out of mutual funds in search of elusive market-beating returns (blowing much of their money on fees and commissions in the process).

Meanwhile, back on campus, a new generation of finance professors has been ripping Fama’s teachings to shreds. The organizing principle for this new breed of scholars is not efficient markets but something called behavioral finance. Behavioral finance teaches that stock market investors are irrational, that future stock price movements are at least partly predictable from past behavior, and that careful analysis of past trends and financial reports can pay off. Which happens to be the way most investors see the market already.

Read more »

The Four Dirtiest Words in Trading

Brian Hunt, writing in the Growth Stock Wire, gives some very important advice: use stop losses!

I heard the four dirty words of trading last week…

My friend had recently purchased stock in a small oil company for around $20 per share. Things weren’t going well for the company, so its share value was down to $8 – a 60% loss for my friend.

Here’s what he said: “It will come back.”

I shuddered at his analysis of the situation. I shuddered at those four dirty words.

This is the mantra of stock market losers. If you catch yourself making this statement, immediately sell all your stocks and stick the cash in the bank.

You’ll be much better off financially if you do. You’ll also have a lot less stress in your life.

“It will come back” is a common reaction investors and traders have after seeing a stock fall 30%… 50%… or 70%. Most folks just can’t stand to admit they’re wrong. Saying “it will come back” allows them to convince themselves they aren’t wrong… just “early.”

It allows them to keep hope alive… and to ignore the elephant in the room: They need an absolutely huge, highly improbable gain just to break even.

Read more »

Are You Smarter than a CFA’er?

SSRN Working Paper:

Several studies have examined whether a manager having an MBA or CFA leads to superior portfolio performance. However, these studies have yielded mixed conclusions. A possible reason is that most have considered only MBA or CFA alone, and most have not controlled for managers’ style targets. We examine MBAs and CFAs together, controlling for market conditions and style targets. We find that the CFAs do add value, but even more significantly (especially in light of events in recent months) – CFAs reduce and MBAs increase Tracking Error.

Read more >>