Category Archives: Myth Busters

It’s Not That Random

I am continually amazed that some people still look at investing as a random walk.  Perhaps this idea stems from the lingering effects of Burton Malkiel’s 1973 book “A Random Walk Down Wall Street.”  Professor Malkeil’s thesis centers on the difficulty of “beating” the market.  He shows that investors who use either technical or fundamental analysis will generally do no better than ones who employ a passive (i.e. index funds) strategy.  His work and all that followed it seem to hold up pretty well when considering the “average” investor and all investors taken as a whole.  In aggregate, investors may not beat the market over time, but that does not mean that every investor fails to beat the market.  His work cannot account for great investors such as Warren Buffett, Peter Lynch, John Neff, George Soros, Julian Robertson, Bill Miller and so on.  It also fails to explain why billions of dollars in hedge funds continue to perform better than the market year after year.

I think some people must find comfort in the idea that investing is random.  Often it appears to be random.  We all have heard stories about somebody’s brother-in-law or cousin once buying a stock and seeing it go up 100% (or whatever).  Often the beneficiaries of this good luck have limited experience with the markets and no formal training.  Thus, this twisted logic goes, if this person can make money in the market, it must not be that hard or it must be random.

From this point of view, it’s very easy to conclude that investment is akin to gambling.  You place your bet (buy a stock, for example), roll the wheel (wait a while) and then either collect your winnings (the stock goes up) or mourn your losses (it goes down).  The idea that there might be a way to remove some randomness from this exercise probably never crosses the gambler’s mind.

Professional investors have many tools available to them, which may be generally out of reach to the individual investor.  Let me briefly suggest four of them which I consider important.  First is time.  Someone who is looking at the market every day as a full-time job is very likely to do better than someone simply doing it as a hobby.

Second is information.  Although the average investor has good access to public documents such as annual reports, their potential information flow is only a trickle compared to that from which the professionals drink each day.  From expensive databases to daily market intelligence from professional prop traders; from direct communication with CEOs to the ubiquitous Bloomberg terminal; from company visits to complicated computer algorithms, the professional has a much better information flow to aid in making decisions.  I’m not talking about “insider information,” the use of which is illegal, but just better and/or more information.  Better information often leads to better decisions.

Third is training.  One does not need a degree in finance, accounting nor the CFA (Chartered Financial Analyst) designation to be a good investor, but it surely helps.  In my view, the better one understands statistics, calculus, economics, accounting, probabilities, corporate finance, monetary policy, taxation, valuation measures, human nature and the laws of physics, the better investor one could be.  Simply buying a stock based on one “high concept” idea (renewable energy, for example), is a recipe for doing no better than the proverbial random walk.

Fourth is experience.  Pattern recognition is an important component of investing, and those who have been through a number of investment cycles (bear and bull markets) are more likely to make good decisions at crucial times, exactly because they have “seen this before.”  I’d be the first to admit that I had many white-knuckle days during the last year, but despite all of the uncertainty and dire pronouncements that “this time is different,” I could draw some comfort from the fact that I had seen similar levels of fear before – both in 1987 and 2000.  These experiences helped to guide me through the worst of the bear market and to prepare me for the next phase of the investment cycle (the new bull market).

I am not suggesting that investing is easy.  It is a very challenging exercise, one that is very different than gambling.  The professional investor has tools that can skew the odds of success in his or her favor.  For those of us who have chosen this path, it can also be a very satisfying and rewarding exercise.