Understanding Why Stock Returns Look Like a Random Process
This is the first draft of text that I need to write for both a technical (academic PhD) audience and lay people. The two versions will substantially diverge, but I’m going to use this draft to get feedback from both sides. If you’re reading it, it’s probably because I’ve solicited feedback from you.
What is Nassim Taleb talking about in his books, especially Fooled by Randomness?
Nassim was one of the first people to write about and internalize into a stock-picking regime that returns from stock and bond picking follow a random process. The title of Nassim’s first book is indicative of the format — it contains stories and reflections about people (academics, professionals, etc.) that are fooled into believing that they are doing something better than returns that would be generated by a random process.
Daniel Kahnamen’s new book, Thinking Fast and Slow, also discusses this topic in detail. Kahnamen’s Nobel Prize and early books, such as this, discuss ways that we fool ourselves into believing that we have a system or approach that is better than a random process would produce over time.
You’re Not Alone in Being Fooled
This concept is so difficult to grasp that graduate students, faculty at Ivy academic institutions, and even Nobel Prize winners, such as Milton Friedman (insert link to the 1948 example) routinely make big embarrassing mistakes about this. One of the reasons that you study as a graduate student is to train yourself to stop making these mistakes (it is still difficult, especially if your faculty don’t know and understand the problem).
Why do we believe that stock returns follow a process that approximates a random process?
If you examine 1500 stock pickers and examine their returns against indexed benchmarks, the returns generated by the pickers follow a normal distribution. This does not imply that all stock pickers have equal performance. It implies that some pickers will do better than others some times. Much better. We will expect to see cases where a stock picker beats the benchmark for 25 years in a row. Every random process has some probability that someone will do the equivalent of flipping heads 25 times in a row. And, when you get enough people doing something, you are bound to have this event occur.
What is the implication for my investing (especially retail investing)?
First, it is extremely unlikely that your performance will exceed the mean over time unless you are engaged in arbitrage and you don’t realize it. One type of arbitrage (that is also illegal) is insider-trading. In this type of arbitrage, the two markets are the current market and the future market. You know the future market price (because of inside information) and you profit from capitalizing upon the known imbalance between the current market price and the future market price.
Second, high frequency traders and market makers are engaged in arbitrage, and they are always fighting against you. These systems know the future price because they are both examining data across a broader range of activities faster than you are and they are dedicated to this activity day in and day out such that they develop statistical histories that represent successful strategies. These two implications together imply that if you are not engaged in arbitrage, it is extremely difficult to beat random performance. (Remember, beating random performance does not imply that you won’t be able to beat the market average once, or twice, or even 20 times in a row! It implies that real returns will probably be distributed normally, at best. Before costs and fees. I can play slots for 5 minutes and win $20. If I don’t walk away, I have to expect that the house will eventually take the money back. Plus more.)
Third, if you are developing an arbitrage scheme, i.e. a plan for picking stocks or bonds better than a random process, I hope you have a risk management plan for handling what happens when the market assumptions that enable your arbitrage process disappear. This is what professional investors are supposed to be doing. They find an arbitrage process that works for some period of time (such as an irrational pricing of Italian bonds that allows profits), they make money from it, and then they need to be ready to move on when that opportunity disappears. When they are not ready, you get massive losses like we’ve seen with Long Term Capital Management, the housing crisis, etc.
