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I wasn't originally going to talk about this next, but I received some comments that I want to address now. Let's make this clear: I'm not going to recommend any companies for you to invest in.
Efficient Market Hypothesis
This is an interesting/controversial idea from academic finance that says, according to wiki, "financial markets are "informationally efficient". That is, one cannot consistently achieve returns in excess of average market returns on a risk-adjusted basis, given the information publicly available at the time the investment is made."
Let me rephrase that in a way that matters to you and me. I have no idea what the heck any company is worth. Neither do you. And here's the kicker -- it doesn't even matter. This is an extremely powerful line of thinking that you should always keep in mind when investing.
For today, we'll use the example of Bank of America (symbol = BAC) as our example to illustrate my points. It should be pretty familiar with anyone in the US, but any large company would make a good example. So let me ask you what Bank of America is worth right now?
- If you're so inclined, you could make a completely random guess, say, $100 billion. It'd be a pretty good answer.
- If you knew some basic finance analysis, you could look at how much money they make, how much money it costs to run the company, guess how much they'll make next year and the year after that, figure out the interest rate, use your nice little discounted cash flow valuation formula and tell me an answer. Not bad.
- If you were meticulous, you'd take into consideration changes in government regulations, the state of the economy, how their competitors are faring, what the CEO's plans for the company are, changes in interest rates, etc. Even better.
- Now if you were a professional, you'd assign some probabilities to every one of those things and maybe even come up with a probability distribution of the value of BAC over the next month or year. That would be pretty baller.
Here's another approach. BAC is worth whatever people are willing to pay for it. (At the time of this writing, around $118 billion.) The stock is trading around $11.66-$11.67 at the close.
But wait, couldn't that price be completely wrong? If you're so sure it's higher, go buy some stock. I'll sell it to you for $11.67. If you're so sure it's lower, sell some stock. I'll buy it from you for $11.66. Now all I have to do is find one sucker who thinks it's higher and one sucker who's lower and I just made $0.01 by being the middleman. Without knowing a single thing about the company or what it's worth!
Okay, so I made a penny... what's the big deal? Well, on average, BAC trades 260 million shares a day. In case you didn't do the math, that's $1.3 million a day, or roughly $300 million a year. Of course, I'm making it sound a whole lot easier than it really is, but that's the basic idea. This guy who knows absolutely nothing about what the company is worth is making millions buying one cent lower and selling one cent higher. All of this with very little risk.
To belabor the point with another example, let's say you're 100% sure that the price of BAC should be $15. You've done a month of research on it in every way possible, and now you're ready to bet your life savings on it. Heck, you've borrowed money from all your friends and family and all their friends and family.
You've raised $5 million to bet that BAC is going up. Now, that's so much money that everyone who's selling it to you must be out of their minds right? You're ready to pay up to $15 for a share of BAC, and they're selling it to you for $11.67?! Your bet is so large that it should at least drive up the price of BAC right?
In reality, $5 million is probably going to move the price of BAC by one whole cent. You know why? Because there's someone out there willing to bet $5 million that BAC is worth less than $11.68. And what makes you think the guys out there betting against you don't have a team of professional analysts studying a company for 3 months and $10 billion of money to work with? People call this capitalism. Free markets. Supply and demand.
Think about that for a moment. How are you ever 100% sure about whether a stock is going to go up or down. Every time you buy stock, somebody has to be on the other side selling it to you. How are you 100% sure that you're right and they're wrong? What makes you think you're smarter than the guy on the other side? Until you can present a compelling argument on why you're better at pricing companies than the rest of the world, there's little reason to think you're right.
How does that apply to people like you and me who aren't professional analysts? It basically means that we really have no insights into whether BAC is above or below it's current price. Investing in individual companies is more or less a coin flip.
Being right is usually luck, not skill. Don't get me wrong, there are professionals out there who have a lot of skill at picking stocks, but there are also a lot of them who are really lucky. The real question is how to tell apart skill from luck?
 
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The efficient market hypothesis hasn't really been found to hold strictly on any market, and absolutely doesn't hold on the less well-known exchanges, like Hong Kong's.
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I'm not arguing whether it's true or not. I'm explaining how that concept applies to the average investor. Thanks for the feedback; I appreciate the fact that you've either taken a class or read a book somewhere.
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How is this a guide? What's your advice? Your conclusion seems to be that investing is all luck. Maybe advise on how to do valuation to find the actual worth of a stock, not just the current price.
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my advice is, unless you're a professional, don't bother with valuation.
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On November 21 2010 14:26 azndsh wrote:
my advice is, unless you're a professional, don't bother with valuation.
So, is this an advocation of the greater fool theory? I think it's pretty risky to assume that someone is always going to be paying the price you bought it for or more. I think markets are efficient enough to revalue the stock eventually and you don't want to be on the losing end of that.
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no, I'm suggesting that you don't even invest in individual stocks.
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On November 21 2010 14:53 azndsh wrote:
no, I'm suggesting that you don't even invest in individual stocks.
All right. I skimmed over your BAC example the first time and got the wrong impression. Looking forward to your next blog. 
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Who's your teacher? This is not how shit works.
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I am of the temple of the almighty bubble. Everything is a bubble. Buy low, sell high, sell before the crash. Diversify and don't invest in the long term.
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On November 22 2010 03:03 THE_DOMINATOR wrote:
I am of the temple of the almighty bubble. Everything is a bubble. Buy low, sell high, sell before the crash. Diversify and don't invest in the long term.
you are a bubble temple impostor
our true mantra is not "buy low sell high", that's amateur-ville
the real bubble templars follow "buy high, sell higher"
=)
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On November 22 2010 02:23 gen.Sun wrote:
Who's your teacher? This is not how shit works.
care to explain to me which part is wrong?
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It is true that is very hard for someone to know when a stock is overvalued or undervalued but this doesn't mean you should not bother doing research before purchasing. Are you suggesting people just buy MF/ETF of sectors? Even then, you need to determine if the overall sector is overvalued or undervalued. How do you know if INDU or SPY is not over extended and should really be trading at 30% lower than what it is right now? When you buy INDU, you are essentially buying a small sample of the economy. Is it easier to determine if the economy is doing well or if a single company is doing well?
My personal belief is to trade charts. I don't care what company it is, I don't care what sector it is. I look at the charts and the charts tell me where to buy and where to sell.
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On November 21 2010 14:53 azndsh wrote:
no, I'm suggesting that you don't even invest in individual stocks.
why would this theory apply to individual stocks, but not funds?
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So if you dont invest in individual stocks.. How can you make money? Lord knows ETFs won't get you anywhere.
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Index funds will consistently and reliably return market average growth, unless you pick some ridiculous index that "indexes" like 4 stocks in some tiny industry.
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Right.. index funds return market performance less expense fees. Yet, the question still remains.. how can i make money? Like.. REAL money. At 10% annual return, SPY isnt going to make me rich.. Maybe this is the wrong thread to post in. Maybe we need a "trading" thread.
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If you expect to make more than 10% return on any investment without getting obscenely lucky or massively outperforming the market, you've got something else coming.
[edit] and the fees on index funds are minuscule
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On November 22 2010 07:41 itzme_petey wrote:
Right.. index funds return market performance less expense fees. Yet, the question still remains.. how can i make money? Like.. REAL money. At 10% annual return, SPY isnt going to make me rich.. Maybe this is the wrong thread to post in. Maybe we need a "trading" thread.
Very good point. This is an "investing" thread. Honestly, if you're looking for 10%+ annual return, you need to be taking on a whole different level of risk. I'll talk about it in an upcoming post.
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That's a very lazy way to look at the market. Trading is like anything. The person who has the most information wins. It takes time and skill to find a promising stock. It is not easy to make more than 10% on your investments but it is very possible and takes a lot of time and effort just like everything else.
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The idea of risk/reward is actually counterproductive, I find.
Its rather more about volatility/reward. If you look at the average returns on the stock market over the last 40 years or something, its like 11% - which is an amazing return, but the only way you got that is if you left your money in an index for the entire 40 years. If you had to take your money out at a bad time, you probably lost 20% on your investment. If you'd put it into Treasury bonds, you'd have made 4-5% max, but you would have made it every single year, without fail, and the only way you'd have lost money was if you had to sell bonds during a bad time to shore up your money.
If you know for a fact that you don't need to take the money out for 10+ years, it is flat out retarded to invest in anything except that which returns the highest on average. There's no risk in stock investing (unless you speculate), but there is risk on getting out of the investment.
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On November 22 2010 08:05 TunaFishyMe wrote:
That's a very lazy way to look at the market. Trading is like anything. The person who has the most information wins. It takes time and skill to find a promising stock. It is not easy to make more than 10% on your investments but it is very possible and takes a lot of time and effort just like everything else.
Again, we're talking investing vs trading. If you want to talk about trading, go make your own thread.
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On November 22 2010 07:33 kzn wrote:
Index funds will consistently and reliably return market average growth, unless you pick some ridiculous index that "indexes" like 4 stocks in some tiny industry.
Define "consistently and reliably." I think you would be surprised how difficult it is to construct said portfolio. Eg; commodity delta ones and contango / equity delta ones and correlation spikes.
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On November 22 2010 08:27 InsideTheBox wrote:Show nested quote +On November 22 2010 07:33 kzn wrote:
Index funds will consistently and reliably return market average growth, unless you pick some ridiculous index that "indexes" like 4 stocks in some tiny industry. Define "consistently and reliably." I think you would be surprised how difficult it is to construct said portfolio. Eg; commodity delta ones and contango / equity delta ones and correlation spikes.
Constructing an actual index fund is easy as hell, unless you have less than the necessary amount to purchase at least 1 share of each stock.
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We believe that these high levels of trading can be at least partly explained by a simple behavioral bias: People are overconfident, and overconfidence leads to too much trading.
Overconfident investors will overestimate the value of their private information, causing them to trade too actively and, consequently, to earn below-average returns. Consistent with these behavioral models of investor overconfidence, we provide empirical evidence that households, which hold about half of U.S. equities, trade too much, on average. Those who trade the most are hurt the most.
Don't trade bro, you don't know what you're doing.
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but why isn't a fund not included in the efficient market theory. They can go up or down based on the same principals right?
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On November 22 2010 08:05 TunaFishyMe wrote:
That's a very lazy way to look at the market. Trading is like anything. The person who has the most information wins. It takes time and skill to find a promising stock. It is not easy to make more than 10% on your investments but it is very possible and takes a lot of time and effort just like everything else.
What you're describing is more like investing. For long-term risk-averse portfolios this is what you want to do. Flash trading, however, is a different animal. StatArb lives and breathes on the $0.01 differences described above, trading millions of shares in tenths of a second. Most of the daily trading volume is just computers moving millions of shares very very quickly.
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On November 22 2010 14:06 geometryb wrote:
but why isn't a fund not included in the efficient market theory. They can go up or down based on the same principals right?
No. Funds are essentially companies whose entire business model is the holding of an index of stocks. The value of a mutual fund fluctuates with the value of its entire portfolio, while the value of a stock fluctuates with the value of that individual company.
Yes, in theory, you could (and people probably do) speculate on index fund stocks, but the degree to which you'd have to be right and the market would have to be wrong to make a lot of money is much larger than with individual companies (and its much harder to evaluate a portfolio than a company accurately).
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On November 22 2010 14:34 kzn wrote:Show nested quote +On November 22 2010 14:06 geometryb wrote:
but why isn't a fund not included in the efficient market theory. They can go up or down based on the same principals right? No. Funds are essentially companies whose entire business model is the holding of an index of stocks. The value of a mutual fund fluctuates with the value of its entire portfolio, while the value of a stock fluctuates with the value of that individual company. Yes, in theory, you could (and people probably do) speculate on index fund stocks, but the degree to which you'd have to be right and the market would have to be wrong to make a lot of money is much larger than with individual companies (and its much harder to evaluate a portfolio than a company accurately).
i still don't see how if you buy one stock you are flipping, but if you buy a collection of stocks you aren't flipping anymore? The EV of 1 flip and 100 flips should be the same, isn't it? Why do we distrust the month of research on 1 stock and believe in no research on 100 stocks? Also, buying anything and hoping it will go up is speculating right whether its a fund or a stock? sorry i am new to this.
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On November 23 2010 02:41 geometryb wrote:Show nested quote +On November 22 2010 14:34 kzn wrote:On November 22 2010 14:06 geometryb wrote:
but why isn't a fund not included in the efficient market theory. They can go up or down based on the same principals right? No. Funds are essentially companies whose entire business model is the holding of an index of stocks. The value of a mutual fund fluctuates with the value of its entire portfolio, while the value of a stock fluctuates with the value of that individual company. Yes, in theory, you could (and people probably do) speculate on index fund stocks, but the degree to which you'd have to be right and the market would have to be wrong to make a lot of money is much larger than with individual companies (and its much harder to evaluate a portfolio than a company accurately). i still don't see how if you buy one stock you are flipping, but if you buy a collection of stocks you aren't flipping anymore? The EV of 1 flip and 100 flips should be the same, isn't it? Why do we distrust the month of research on 1 stock and believe in no research on 100 stocks? Also, buying anything and hoping it will go up is speculating right whether its a fund or a stock? sorry i am new to this.
lol, you're absolutely right and I specifically replied to you in my next post. not really sure if the other guy doesn't understand what you're asking, if he's just framing his answer wrong, or doesn't know what he's talking about =/
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On November 23 2010 02:41 geometryb wrote:Show nested quote +On November 22 2010 14:34 kzn wrote:On November 22 2010 14:06 geometryb wrote:
but why isn't a fund not included in the efficient market theory. They can go up or down based on the same principals right? No. Funds are essentially companies whose entire business model is the holding of an index of stocks. The value of a mutual fund fluctuates with the value of its entire portfolio, while the value of a stock fluctuates with the value of that individual company. Yes, in theory, you could (and people probably do) speculate on index fund stocks, but the degree to which you'd have to be right and the market would have to be wrong to make a lot of money is much larger than with individual companies (and its much harder to evaluate a portfolio than a company accurately). i still don't see how if you buy one stock you are flipping, but if you buy a collection of stocks you aren't flipping anymore? The EV of 1 flip and 100 flips should be the same, isn't it? Why do we distrust the month of research on 1 stock and believe in no research on 100 stocks? Also, buying anything and hoping it will go up is speculating right whether its a fund or a stock? sorry i am new to this.
Are you talking about buying one stock, chosen at random? Because then, yes, the EV is identical to an index fund. However, the actual value you're going to get is much more variable (which is what I was talking about before), and in the case of buying a random stock every year you might not ever make a positive return before you die, because there are so many stocks. I'm talking more about trying to pick the stocks that are going to rise, which has proven consistently difficult for people to do even when they're being paid millions to do it.
When I say speculation, I mean what I just talked about: trying to buy a stock shortly before it goes up, and selling it rapidly to crystallize that gain (and doing the reverse). Index fund investing is theoretically open to speculation, most people who invest in index funds do so with the intention of just getting growth equal to the average market growth - they don't particularly care if the index fund is overvalued or undervalued, they just care what kind of % return they're going to see on their money.
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EPT
