Thursday, July 31, 2008

The end of Alpha

A few hundred years ago, humans were not capable of calculating the speed and acceleration of apples falling from trees, the movement of heavenly bodies and predicting simple things like whether a 2kg ball and 1kg ball will roll down a slope faster. Btw the answer is both balls will roll down the slope at the same speed.

Then came along a guy called Newton who sat down in a park some day and an apple fell on his head. (I'm guessing this guy is a nerd and has no dates!) And as they say the rest is history. Well no offense, Newton was a great guy and I admire him as much as the next value investor reading this blog.

Anyways, the analogy here is that would there be a day when humans can fully predict the prices of stocks and all other investments? And all securities would be priced fairly all the time and there would be no room for speculation and the market becomes truly, madly, deeply EFFICIENT.

Of course, even a genius like Newton failed at winning the stock market (he speculated in the stock market in England during the South Sea Bubble and lost a lot of money) so it may really take a long long time for some achievements on this front. And some may argue that this would not happen bcos stocks move on emotions and no one can predict human emotions. Esp the emotions of the woman whom you decided to spend the rest of your life with.

Well... that's true... but we have also achieved a lot of impossible feats, like going to the moon, heart transplant, calculating a 2 to power of 10mn digit prime no. etc. So let's just for argument sake postulate that some day, all securities are priced efficiently all the time.

What's gonna happen is that capital would be allocated efficiently all the time, all investors will earn the same rate of return and there will be no Greater Fool Games, no bubbles and no crashes.

The stock prices of companies will be step functions corresponding to the growth of the companies. There would be no technical analysis since it's all straight lines now. Any new developments will be instantly reflected in the stock price so you see the prices move vertically up or down. Hence the step functions.

There would be an army of arbitrageurs who would bring the stock price back to its intrinsic value if any punter tries to even move the stock price by 1/256 from its intrinsic value. Btw this value will be calculated accurately to the 10th decimal place all the time and changes accurately to a new value with new pieces of information.

Brokers would still be around but their sole purpose would be to faciliate any trades. They will earn their fair share of commission, probably at 0.0001% of the trade or whatever. There would be no need for analysts or economists babbling nonsense since everyone can simply use bloomberg to find out the intrinsic value of any securities.

Fund managers exist solely to mix and match different securities to create suitable portofolios for their clients who are too lazy to do it themselves. No investor will ever lose unnecessary money except for the case of company bankruptcies. But even so, his portfolio will be protected by insurance. How perfect!

Well, that's a dream. It may happen someday, but most probably not in my lifetime.