Efficient Market
I read an interview today in which the person being interviewed commented on effient markets. Although some people can consistently beat the market, 90% cannot. And what's always cited is the Morningstar data that 90% of the mutual funds cannot outperform the market averages so that you are better off with an index fund.
Okay, but let's look at how they define performance. Satisfactory performance is outperforming some benchmark like the S&P 500. And if you cannot outperform it, then staying close is okay. But let's look at the rules: 1) a mutual fund has to remain about 95-98% invested; they cannot go to cash because they don't like the market conditions; 2) the best way to stay close to the benchmark is to own the benchmark -- so they do. So let's say during the year, as a mutual fund, you are about 90% invested in the S&P 500. You give yourself about 3-5% leaway to try to outperform it. However, you also have 1-2% fees that your charge the public. What are the chances of you beating the market. Almost zero!
Thus, the evidence that people support for market efficiency is ridiculous.
Also with trillions of dollars, its very difficult to move in and out of things without moving the market. So big funds, by nature, should have a difficult time beating the market.
However, my belief is that anyone with a million or less could easily double their money each year. It doesn't take real genius to develop a system that could make 100 trades with an 0.8R expectancy, thus giving you about 80R per year in returns. The real genius is being able to be efficient as a human being and actually achieve that return without making mistakes. And if you want to know about mistakes, see my other posts (I still want to call them blogs because I make the rules on this one).
Comments
For those who believe in market efficiency as academic people do and teach I recommend find out more about Prospect Theory by Kahneman and Tverski, which I think is part of Behavior Finance.
Just think about it.
Krasimir
Posted by: Krasimir | September 13, 2006 08:16 AM
Excellent efficiency theory tidbit about the mutual funds requirement! Ya learn something new everyday, if you are open to it!
John
Posted by: John Yoga | September 20, 2006 05:02 PM
I'm surprised you didn't point out one of the biggest fallicies. Indexes like the S&P, for example, are determined by human beings and the rules that they make! It's really logically incoherent to say that it is impossible to outperform the market, since the measure of the market is just the decisions made by another group of humans!
Posted by: bwilhite | September 21, 2006 12:16 PM
Another commonly cited piece of 'evidence' for the Efficient Market Theory:
--
"In comparing backtested returns on US equities, a 'buy and hold' methodology nearly always beats anything with a higher trading frequency, especially those based on analysis of market price and volume data."
--
But the backtests are ALWAYS on US EQUITIES. Talk about a myopic data sample! US Equities have had a very strong expansionary bias, because of 1) consistantly positive dollar inflation and 2) unprecedented, consistant economic expansion of the US economy.
Try using a more 'balenced' data sample, for instance, treasury futures. Try a buy-and-hold there!
Along with many classical economic theories that are simply too rudimentary, EMT suffers from the fact that economic markets (whose data is widely reported) are complex, self-reflexive systems with *major* feedback loops, i.e., a large part of the system input comes from participants' perception of the system's output -- traders get much of the *input* for their 'rational' decision making from the *output* of the system itself. And it makes sense -- if price discovery could be done using only 'fundemental analysis' of relevant market forces, there would be no need for a trading market at all!
Posted by: Nick | September 22, 2006 09:59 AM