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.


  1. Our Sir Isaac Newton predicted the world would end in the year 2060.

    If we are going to believe it, there is still 52 years to realise your perfectly efficient stock market ideology.

    If we are going to prevent it, let's do our best to protect our Earth.
    Carbon emission control and Green energy investment funds are instrument invented to safeguard our Earth.
    We are far too slow, but we should also glad that we are moving forward.

    If we choose to not believe what this ancient people said, (Between, i respect him), let's waste more, consume more, throw more things.
    Inevitably, next generation will suffer.

    No matter we choose to believe which scenario, or you may invent your own interpretation of it, i choose to believe a
    True Value Investor with the wisdom of running a business will continue to shine, at least for the next 52 years..

    Save the earth.

  2. There is this book called the Skeptical Economist arguing that the statistics arguing for global warming, environment meltdown etc isn't really statistically significant. Over the history of the earth, temperature rising by a few degrees is a normal thing.

    He is not saying that we should not be green, but he is saying that there are more important issues to solve rather than hopping on the green bandwagon.

    E.g. poverty, diseases, children's education in developing countries, food shortages etc.

    These problems are much much more impactful than environment issues. How many birds/fishes/humans died bcos of global warming?

    Well I don't know but I think compared to billions living on less than $1 a day, environment issue is not an issue, at least to the girl thinking whether she can have her next meal.

    Then again, it doesn't mean we shouldn't be green, it is morally right to be green, but harping it all day is a different story.

  3. very interesting article indeed. understand that it is your view that the market is inefficient to an extent. However, I am of the belief that the market is actually full of intelligent investors around. Therefore, whenever I choose a company to invest in, I will always find reasons behind its relative "underperformance", if any, which I think the market has either overlooked or is overly bearish about. Love to hear your comments.

  4. Actually I believe the market is pretty efficient. It is very hard to beat the market over a long period of time (ie 10 yrs or more).

    I believe that your investment philosophy is very correct, but in practice, it is very hard to perfect. Usually the market doesn't overlook too many things. Except when your investment horizon is very much different from the market's. The market doesn't like to think to far ahead.

    Good luck!

  5. I have to say that the market is actually highly efficient. However, I believe that the market is only efficient in pricing available information into the stock prices.

    I do not believe that the market can accurately reflect that information into prices.

    The simple reason is that there will always be different people taking a various viewpoints as to the fundamental situation of a company or information available

  6. For the reason that Mr./Ms Augustine stated, they can argue that the market moves in random and will reach an equilibrium position.

    It is hard to beat the market, but in my opinion, if Value Investors do not wish to beat the market, then all of us can go for party together after purchasing some low cost index funds.

  7. I believe that the market will hit an equilibrium in the long run, but that's not the point I was trying to make.

    My point is that since humans are the ones pricing the market, there will always be undervalued and overvalued companies. This, coupled with the effect of a herd mentality will result in opportunities for the value investor to exploit.

    btw, its a guy's name

  8. Yes it is very hard to control emotions, but it is not impossible.

    I was watching the all exciting table tennis semi finals, the players that can have the psychological edge wins!

    They trained their minds so hard so that they can control their emotions and try not it affect their play.

    Of course it will take a lot of time for all the market participants to do that.