THE BEAUTY PAGEANT ANALOGY
It must never be forgotten that the stock market is a game of PICKING THE
WINNER OF THE BEAUTY PAGEANT. It is not about picking your own choice
to win. It is about predicting who the judges will pick. If you know the
judges are racist scum, there is absolutely no point in picking the
pre-eminently superior girl with the wrong skin tone. Your job is to know who the judges like, before they make it public.
The Efficient Market
You may be thinking that this analogy contradicts the Efficient Market Hypothesis.
But (depending on your POV) the theory does NOT mean that the market is always correctly
valued. When academics discuss efficient markets, they almost always
mean informational efficiency - stock prices fully reflect all relevant
information (data). But markets also reflect all the participants'
sentiment. That sentiment determines how the data is projected into
Informational efficiency does not say that prices are fundamentally
correct. If even a substantial fraction of investors make the same
error, the consensus can diverge significantly from true value. In
fact, finding a 'true' value is not the objective of most investors.
Most are concerned with how (under the influence of mass psychology)
the market will evaluate the investment three months or a year hence
Stock prices trend. They do not jump in value with the release of discrete pieces of information. Any new information is acted upon by a small population to start. The stock's price movement and the media alert other investors. An established price trend attracts technical traders. The trend ends, most likely, when the markets are exhausted - when euphoria becomes pragmatic, when all the potential buyers already hold full positions or have already made their profits and sold. The trend reverses, not necessarily when new information becomes available, rather when the market runs out of new buyers.
R. Ferguson wrote a fun thought experiment in 1983 that destroys Efficient Markets with common sense. Z. Berkstresser (2010) wrote a tongue in cheek paper listing the assumptions of an Inefficient Market Theory.
- People possess heterogeneous utility functions due to varying reinforcement schedules.
- All investors are not risk averse, exhibited by the gambling urges of people.
- The relationship between risk and return need not be symmetrical and can be curvilinear. The great investors who continue to achieve greater returns with lesser risk prove this fact consistently.
- Investors by their nature tend to follow the crowd and therefore they create a dependency on what others are doing.
- Information need not come to the market in an independent fashion. Historically and today, information continues to be used for the benefit of the few - which creates inefficiencies in the market place.
- Individual and institutional investors like all people tend to be irrational by their nature. Because of this, markets over long periods of time take wide swings to overvaluation and undervaluation.
- Most investors will miss major buying and selling opportunities because of their misperception that markets are fairly priced and are truly reflective of proper risk levels.
- Even if capital markets become informationally efficient, this will not necessarily create an efficient market because investors over long periods of time tend to follow the crowd. Bubbles will never cease, because the human condition is a reliable constant. Proficient investors will continue to consistently produce greater returns will lesser amounts of risk.
People with a public voice can change a market's opinion and make
more easily than the Retail Investor. These people are in the locker
with the judges. They have both the power to persuade the judges and
power to report back to you, falsely, what the judges are thinking. The
Retail Investor must ask himself "Is the public voice honest - or
bets to better his own odds? All people with a public voice have
conflicts of interest vis-a-vis the retail investor. Consider what they
might be before you listen.
Being 'correct' about a company's value won't make you money in the
stockmarket - not unless and
until the market sees the error of its ways and is persuaded to agree
you. The market can remain irrational longer than you can remain
solvent. It's liquidity is a wonderful attribute. Don't fight it.
When you identify a metric that the market is ignoring (e.g. high
stock-options costs) there is no point in trading on that analysis. The
situation probably will not change in the forseeable future. All you
can do is ignore the stock, and move on to another. Similarly, some
stocks' prices are controled by technical traders. No matter what you
think of technical analysis, don't assume your fundamental analysis
will triumph any time soon.
The game plan is to be correct without being TOO correct.
- Think for yourself but listen to the market.
- Don't take positions that are too extreme.
- Understand the valuation metrics being used by others ... and their
- Try to predict when that metric will eventually change to agree with
The Capital Asset Pricing Model (CAPM)
Modern finance is based on a model of the markets that assumes a rational investor who expects to earn a higher return when buying a riskier stock (as measured by the volatility of returns). Put another way, for a given exposure to uncertain outcomes, investors prefer higher rather than lower expected returns. I.e. the risk-return tradeoff. This is the CAPM.
By capturing the idea that markets are inherently rational, the CAPM has made finance an appropriate subject for econometric studies. It has justified finance as a subject worthy of scientific inquiry. So when holes in the theory are found, adjustments to the central framework are added, while defending the central hypothesis.
How you personally think the market works will colour many of your actions. Retail investors should feel free to form their own opinions based on common sense.
- Your choice of strategy between stock picking and passive indexing will depend on whether you think markets immediately and correctly price all new information.
- Your choice of personal benchmark may be risk-adjusted depending on whether you feel the attributes that explain market prices are 'risks' or not.
- Your acceptance of the Fama-French variant of the CAPM is necessary before you accept the studies of retail investors' returns in the Active Vs Passive debate.
- The use of stock screening as a method for finding investments depends your understanding of what those factor-models mean.
"Before CAPM, the understanding of the markets was that stock prices generally respond positively to good news and negatively to bad news, with market sentiment and crowd psychology playing a role that is never easy to determine, but which at times appears to produce tipping points, sending the market to booms and busts. " (ref).
The original CAPM had only one factor - Beta. (See the discussion on the Risks page). It said that all assets have a return equal to the risk-free rate (government T-bills) as a base, plus the market's risk premium multiplied by the asset's exposure to the market (Beta). The problem was that this equation does not explain real-life prices. It does not work. And it has been known to not work for a long time.
Black, Jensen and Scholes (1972) showed that actual data confirms the null hypothesis of the CAPM - that investors have a single expected return for all assets. Fama and French came to the rescue in 1996 by adding two additional factors to the CAPM equation. One factor distinguishes between small and large cap stocks. The other distinguishes between cheap and expensive Price-To-Book metrics.
The F-F model is presented as a refinement in the spirit of the CAPM. And it does seem to explain prices seen in reality. The additional factors are labeled as 'risks' in keeping with the risk-return model. Beta is retained as one of the factors, even though F-F admit it adds nothing to the equation. In reality their model has only two factors, and the Beta variable is redundant. Their equation has an asset's expected return equal to the market return (as a base) +/- sensitivity to size and valuation.
Post F-F an avalanche of research has mined the historical data looking for other factors that better explain stock prices and anomalous returns. See lists and discussion on the Screening-Backtesting page. It has been impossible to characterize all these factors as 'risks'. Even the F-F factors have been shown to have little/no relation to any investor's perceptions of risks.
So has the risk-return model collapsed? Essentially - yes. but academics just won't let go. They have stopped using the term 'risk' in favour of 'factor' models, but the models are still used to dismiss excess returns as due to 'risk'. Some academics now, are looking for explanatory factors in the general economy - using interest rates, credit spreads, market cycles, liquidity and money-flows. But these represent radical departures from the essential risk-return premise of the CAPM - not refinements of it.
Razeen Sappideen paper: a good overview of the current understanding of Efficient Market Hypothesis problems.
Jack Treynor - "Long Term Investing" (1974): a rare source distinguishing between efficient markets being correct vs just popular. Republished on his death.