Friday, May 22, 2009

Does Superior Information Exist In The Context Of The Stock Market?

Meet my uncle, he is an incredibly wise man. He was explaining the mechanics of the stock market to me, specifically the part where most people think that it is all about being in possession of superior information, that somehow a small collection of people always call it right, that they know in advance.

He says it is all bollocks. It is all random. Well I was stunned. So he went on to explain.

You see, in order to believe that an asset manager, or “guru” for that matter, has superior selection skills you have to agree that he, somehow, has access to superior information all the time, well at least greater than average. If this is the case then superior performance has to be evident relative to a randomly constructed portfolio. In other words if we were to construct a portfolio by throwing darts at a dartboard, this portfolio should not outperform the “gurus” right?

I mean doesn't it just piss you off that there are always people that apparently have the inside track? The obnoxious chap at the braai that is ALWAYS right, the radio guru making recommendations, many of the financial advisors and your personal stockbroker. The one that sells you something in the morning, and then phones you in the afternoon to tell you, you are "backing the wrong horse".

So I thought I would test my uncle's theory against the best of the best. Surely a random portfolio would be beaten by the "gurus".

Let’s take a look.

I constructed 5 random portfolios (using the MS Excel random number generator) of 10 equal weighted stocks each. I compared these mere 5 to 240 collective investments (unit trusts). So the "gurus" had 32 times as many opportunities to beat the random portfolios.

Guess what?

A random portfolio beat 99.17% of ALL unit trusts?

"The difference between luck and skill is seldom apparent at first glance." - Peter L. Bernstein

I am not suggesting that this is a viable strategy, it isn't. I am merely highlighting that nobody has closely guarded secrets, that lead to superior performance. Moreover, superior performance cannot be judged on a 1 year performance horizon. It will take at least 20 years.

Update: And I bet you if my uncle gave his fund a name, say Blue Sky Alpha Plus, some of you would even invest in it.

3 Opinion(s):

Viking said...

nice one!

Joe King said...

You know uncle, what always amazes me is that the same people that do not beleive in fortune tellers, beleive in financial advisers. I recently attended a presentation of a stock market programme and asked the question that most people did not think of. I asked the well-informed presenter, if he was wealthy (in the monetary sense). He replied that he was not. Then i asked him why he did not use this expensive money printing program. That is about the time that we all retired to the bar. Did not mean to affect his livelihood, but "not with my money"

Vanilla Ice said...

@Joe. I haven't addressed charting software specifically, but you are correct. They are sold on a false premise, that there are replicable patterns. Moreover, that you could repeat the process sufficient times, to cover trading costs and income tax; and still make a profit. There are no patterns, and a simple auto-correlation test verifies this. Good thing you never handed over your money, and if you ever feel insane enough to do it, there are free packages.