Presently, I have taken upon myself, the task of learning more about how to (efficiently) invest in the stock market. There are two reasons for this: 1. I am a stock market dummy, and 2. I miss not writing about investments and stock market on this blog. The depth of my lack of judgement in this matter will be very clear if I mention the fact that my first ever investment in the stock market was in WorldCom….just a few months before it collapsed! Fortunately, it was just an experiment and I didn’t loose much in the debacle.
Ok back to the subject. So I was reading a few things on the internet and came across this website which describes the work of Eugene F. Fama, in which he concluded that the behavior of stock market is essentially unpredictable (this was done in 1965). The theory made a lot of financial analysts and investors uncomfortable. Here is an interesting story that follows Fama’s theory:
At the 1968 Institutional Investor conference, one irate money manager insisted that what he and others did for investors had to be worth more than just throwing darts at the Wall Street Journal. The “dart board portfolio” soon became a new benchmark for active investors, appearing in newspapers, magazines, and in a 1992 20/20 ABC news segment entitled, Who Needs the Experts? In that segment, a giant wall-sized version of the Wall Street Journal was made into a dartboard. Reporter John Stossel threw several darts as he described the firms he randomly hit. The results of that portfolio were compared to those of the major Wall Street Firm experts. The darts beat ninety percent of the experts! When ABC requested interviews with several of these expert firms, none of them would speak or comment on their humiliating inability to beat the darts.
If you are game, you can try this yourself (of course, at your own risk) and create a model portfolio and see how it goes from there. 
May be you won’t make a killing, but my engineering instincts are ready to give you some hopes.
If you are unsure about what I mean by “engineering instincts”, it’s time for you to read Dilbert more often.
To put a closure, Fama’s work suggests that the stock market is mainly governed by randomness due to a variety of factors. Due to this random nature, very complicated mathematics is required to attempt the prediction of performance at a future date. Investors don’t appreciate this fully, but the very idea of portfolio diversification is based on this kind of market behavior. If it were possible for financial analysts to *guarantee* better performance for certain stocks in future, there would be no need for any diversification.
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If you haven’t already, you should read ‘A Random Walk Down Wall Street’, by Burton G. Malkiel (he’s mentioned on the website you linked to). In it he provides an excellent overview and analysis of the evidence in favour of the unpredictability of the stock market, and the virtues of index funds. It is an excellent book - very well researched, engaging and informative. By far the best book I’ve yet read about investing in the stock market. It was originally published in the early 70’s, and is now in it’s 9th edition. You should be able to find it at your local library.
[Completely unrelated aside] Astoundingly, here in Australia the only company offering index funds to individual investors is Vanguard - and they only started their first fund here in 1998! I think most people here are completely unaware of index funds and their benefits - a tragedy considering that mutual fund fees here seem to be much more expenseive than they are in the States. Even Vanguard’s fees start at 0.9% (compared to
Nick, I am sorry..did the blog give you trouble while commenting? I see your interesting comment didn’t quite make it till the end.
Thanks for mentioning the book, I will look it up in my school’s library.
I simply must dig out the old dartboard…lol. I’ve been trying to make sense of investing in the market as well. Looking forward to your posts/finds!
Yeah, my comment semi-disappeard. All I was going to say was that Vanguard’s fees, which seem to be among the lowest in the industry, are 0.9% in Australia, compared to 0.3% or less in the States. I’m assuming it’s due to the different tax laws. So yeah, not terribly interesting or relevant. Sorry for the mini-rant.
In summary, ‘Random Walk’ = good.
Hi there, good for you Golb! I started investing at the age of 22 right smack in the midst of the Iraq-Kuwait war. Little did I know that a powerful bull market would eventually follow that terrible bear market. I got tremendous encouragement from how things unfolded in the market and it helped me stay the course. It’s going to take more patience this time but shouldn’t stop us from making our money work for us.
What you are referring to is the efficient market hypothesis (EMH) and specifically that all information about a stock is immediately incorporated into its price. However, Fama himself backed down from many of the tenets of EMH in the 1990s. There is much, much more to this particular theory than “A Random Walk Down Wall Street” implies. Many studies done since the original thesis have shown that stock prices are not efficient in the way EMH implies. In addition, modern portfolio theory is not the panacea that this article makes it out to be.
If you are serious about choosing your own stocks, you should do much more than a few days’ research. Reading papers from the 1970s and believing that the theory has not changed at all is a recipe for disaster.
Be careful, also, with the statement that most professionals cannot beat the market. You have not mentioned it but I am sure you have heard it. Institutional investors may have different time horizons (year to year) than individual investors. In addition, many of them are more concerned with beating their peers than the market.
If you do not want to spend time doing serious research, then forget what other people say about stocks and just buy some index funds.
Chris: thanks for the valuable comment. Since this post, I have been reading more into random market behavior and trying to understand some more fundamental things. I am sure things have changed since Fama’s time, but I started from there just to get an idea of the general scheme of themes.
I would be very cautious before saying something like “professionals cannot beat the market”
I don’t think this (or the contrary) has been proven conclusively. So it’s just someone’s hypothesis.
Personally, I resonate with your thoughts on doing extensive research before picking stocks..and I intend to do just that (ideally).
Trying to invest in stock market is published and taught in a very wrong way.
What is taught and published is to do trading and speculating not “investing”.
I do not understand what Fama’s work suggests (I got to read the book) -
Are you saying that there is a complex mathematical way to predict the future performance?
Are you saying that by diversifying you can beat the market?
Or Diversification is the holy grail?
What I know is that
1. No one would never able to predict the market
2. One can lose money despite Diversification and a lot of fund managers do despite full-time effort.
3. Diversification is done for hedging.
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