Tuesday, August 7th, 2007
How my trading survived a closed encounter with efficient markets
On my recent break from trading and blogging I read William Bernstein’s excellent book, 
The Four Pillars of Investing.
As the editor of a growth blog it may seem like a strange choice: Bernstein is verging on hostile to growth investing.
Bernstein is a big believer in the Efficient Market Hypothesis (EMH), which basically says: don’t bother trying to beat the market because, over the long run, no one does. (EMH advocates say Buffett, Lynch, etc, are just lucky).
I need (sometimes, I think, unfortunately) to understand the underpinnings what I’m doing; so I’ve spent quite a lot of time thinking about the EMH and what it means for trading.
If I believe the EMH is true, shouldn’t I just stick my money in an index fund and forget trading? To be honest, I was actually considering doing just that.
As it turns out, Bernstein’s book has somewhat changed my perspective; but I’m not about to ditch trading just yet.
I believe that EMH largely holds true: that is, the markets are efficient most of the time and, given trading costs, it’s difficult to beat an index fund over a long period.
So why haven’t I junked trading?
The EMH is actually under sustained attack. Some academics are now trying to explain apparently inefficient markets — such as bubbles — using behavioural finance (which basically says humans can be irrational, therefore leading to inefficient market outcomes).
Knowledge is a dynamic process: what we assume to be truths now can be challenged and debunked within a decade (or decades).
There is a big risk in assuming the EMH is totally correct. In a few decades we could all be looking back at it thinking how quaint it was and that behavioural finance provides the best explanation of markets.
Despite attacks, I accept that the EMH is largely true. But I could be wrong. So I now view my trading as a hedge against EMH being incorrect.
I’m not the only one who’s hedged their bets on EMH being wrong. Warren Buffett’s partner, Charlie Munger, when discussing EMH, told a funny story of one Berkshire Hathaway investor:
“And it’s rather interesting because one of the greatest economists of the world is a substantial shareholder in Berkshire Hathaway and has been for a long time. His textbook always taught that the stock market was perfectly efficient and that nobody could beat it. But his own money went into Berkshire and made him wealthy. So, like Pascal in his famous wager, he hedged his bet.”
The caveat is: anyone who tries to beat the market is going to have a tough time and must have an edge that isn’t going to disappear quickly.
I believe there are two ways to achieve this:
(Article continues below)
a) Develop a highly specialised niche that exploits the irrationality and emotions of investors (such as momentum, or overbought and oversold conditions), or
b) Become a ‘trading scientist’ to constantly find inefficiencies and profit opportunities in markets as they change and evolve
For the individual investor with limited resources, the first option is probably best. You won’t have to complete head on with hedge funds employing legions of Phds scouring the market.
Personally, I have spent almost six years learning ‘aggressive-growth’ momentum trading, which combines rules and a feel for changes in demand and supply.
As I’ve pointed out before, momentum in stocks (strong stocks remain strong, a least for a while) is one area that the EMH can’t explain. Behavioural finance has an explanation for this. So I feel on solid intellectual ground with my trading system.
The other reason I’m not prepared to give up trading in the light of the EMH is simple: trading = hope. As Bernstein says, sticking your money into index funds, by definition, means you’ll never get hugely wealthy.
Trading provides a small prospect of climbing above the pack. Most of my wealth will be in index funds earning a good return and securing my retirement.
But a good chunk of my cash is for trading where I take substantial – but not reckless – risks. This could be irrational, but I’m willing to keep the hope alive - and hedging against the EMH being wrong - by giving it a shot.
Word Count: 667. This entry was posted on Tuesday, August 7th, 2007 at 11:10 pm and is filed under Uncategorized. You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response, or trackback from your own site.
August 16th, 2007 at 3:53 am
The market would be efficient, except that it is not. People trade on fear, greed, which by nature is not efficient. As Buffet points out, people may have knowledge, but do not act. That is where the efficient market theory does not work. Just because you believe based on all information available that a stock is to high, does not mean you will have the courage to act on the knowledge.