Reconciling "Random Walk" with "Market Wizards" [Archive]

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eastbay

05-13-2005, 02:04 AM

I just read two books. The first was "Market Wizards" which is a series of interviews with successful traders, and as one example features a guy who entered a 4-month trading contest and won 9 out of 10 times by a large margin each time, by the name of Marty Schwartz.

And yet, on page 245 of "A Random Walk Down Wall Street", Malkiel makes the somewhat astonishing assertion that:

No one person or institution has yet to produce a long-term, consistent record of finding money-making, risk-adjusted individual stock-trading opportunities.

Now, I guess the catch-all "out" for this statement is "long term" and possibly "risk adjusted" although it's unclear to me what he means by that latter. But whatever example you point to, you could always just say "Not long term enough." But the claim in Market Wizards is that Schwartz has produced "enormous percentage gains every year since 1979." Now that's a somewhat vague statement, but it certainly sounds like a counterexample to Malkiel's assertion.

In any case, how can Malkiel make a statement like this if guys like Marty Schwartz really exist and really get the results they claim to?

There's really only two possibilities here: the so-called "Market Wizards" are frauds, or Malkiel is wrong.

Which do you think is closer to the truth?

eastbay

Soxx Clinton

05-13-2005, 04:03 AM

Warren Buffett made an interesting comment about trader performance records with his famous "coin flipping contest" argument. ie. Even with millions of participants in a huge tournament someone will still win the tournament. Does that make the winner an expert coin flipper?

That said, having read both books, and being a portfolio manager by trade, I think that there is a grey area in between the two books. I think it is possible to beat the market (and have consistently done so myself) but like anything else worthwhile, it is fairly difficult to do, is a lot of work, and takes a certain disposition.

For most people I think trading is -EV. This is confirmed by the numerous studies on retail trading accounts, mutual fund performance, day-trader failure rates, and even independent floor traders who constitute a hugely motivated and full-time group.

In other words, who wants to spend hours a day working on trading when you only have a ~10% chance of beating the market. Of those ~10%, how many beat the market by say double-digits per annum? If not, does the extra 5% a year compensate for the time, training, and stress of just holding the SPY's which if you hold them long enough are an almost sure thing?

eastbay

05-13-2005, 05:25 AM

Soxx Clinton

05-13-2005, 06:21 AM

The point of the coin flipping example is that looking back in hindsight, six sigma traders are inevitable. I think this is ultimately how the two books reconcile somewhat. One could argue that Schwager is guilty of "data-snooping".

Don't get me wrong- I certainly wasn't making the case that the market is unbeatable. I think it is for the people with right skills, mindset, and work ethic. Fortunately for me, these people are pretty unusual. /images/graemlins/wink.gif

edtost

05-13-2005, 12:06 PM

[ QUOTE ]
No one person or institution has yet to produce a long-term, consistent record of finding money-making, risk-adjusted individual stock-trading opportunities.

[/ QUOTE ]

Let's expand the quote a bit and see if his statement makes a little more sense:

"What Do We Mean by Saying Markets Are Efficient?

I'd like to relate it to a well-known story that tells of a finance professor and a student who comes across a $100 bill lying on the ground. As the student stops to pick it up, the professor says, "Dont't bother--if it were really a $100 bill, it wouldn't be there."
[...]
While there are some who agree that there areno $100 bills lying around, an even greater number insist that there's still lots of loose change. The debate on just how much loose change there is, and whether there is any dependable way to pick it up, is a subject that has made many academic careers.
[...]
No one can consistently predict either the direction of the stock market or the relative attractiveness of individual stocks and thus no one can consistently obtain better overall returns than the market. And while there are undoubtedly profitable trading opportunities that occasionally appear, these are quickly wiped clean once they become known. No one person has yet to produce a long-term, consistent record of finding money-making, risk adjusted individual stock-trading opportunities, particularly if they pay taxes and incur transactions costs" (Malkiel 244-5, emphasis added in bold)

Note that Malkiel's book is about things that small individual investors can take advantage of - unless this Marty Schwartz was a mutual fund manager, using his strategies would likely result in prohibitive trading costs for a small investor.

Also, optimal strategy to make it likely for him to win a 4-month contest probably includes taking on an absurd amount of risk, much greater than what the average reader of Malkiel's book is willing to expose themselves to.

Paluka

05-13-2005, 01:51 PM

[ QUOTE ]
[ QUOTE ]
Warren Buffett made an interesting comment about trader performance records with his famous "coin flipping contest" argument. ie. Even with millions of participants in a huge tournament someone will still win the tournament. Does that make the winner an expert coin flipper?

[/ QUOTE ]

Obviously not, but I think the analogy is poor.

[

[/ QUOTE ]

I don't think the analogy is that far-off. My experience is that a good portion of the people profiled in the Market Wizards books are the "coin flippers" who got lucky. There are some notable exceptions, including the guy I work for.

eastbay

05-13-2005, 02:01 PM

[ QUOTE ]
No one person has yet to produce a long-term, consistent record of finding money-making, risk adjusted individual stock-trading opportunities, particularly if they pay taxes and incur transactions costs[/i]" (Malkiel 244-5, emphasis added in bold)

Note that Malkiel's book is about things that small individual investors can take advantage of - unless this Marty Schwartz was a mutual fund manager, using his strategies would likely result in prohibitive trading costs for a small investor.

[/ QUOTE ]

The Market Wizards book is mostly guys who started with a few tens of thousands of dollars or less. Marty started with $20k in the 70s, which is a substantial amount but not totally out of reach of ALL individual investors (remember, Malkiel's statement says NO ONE.)

Second, if Malkiel is going to make such a huge assertion, he should qualify it appropriately. He did not say "no one without N$." He did not say "no one without experience". He said NO ONE. I think the statement is plainly false by counterexample. Warren Buffett?

[ QUOTE ]

Also, optimal strategy to make it likely for him to win a 4-month contest probably includes taking on an absurd amount of risk, much greater than what the average reader of Malkiel's book is willing to expose themselves to.

[/ QUOTE ]

Maybe, but 9 wins out of 10 is at least partial evidence that the risk was worth the reward.

eastbay

judgesmails

05-13-2005, 02:07 PM

I agree with Malkiel on his statement but I don't totally buy into the random walk theory.

Nor do I believe that Schwartz has produced "enormous percentage gains every year since 1979." That is simply impossible in literal terms.

John Allen Paulos does a great job of laying out many market theory's in his book "A Mathematician Plays the Stock Market." One point that he makes that I have really carried with me since reading it is that many market "gurus" like Buffett, Peter Lynch, or John Neff have an effect on the market and their stock choices can become self-fulfilling after a short-term period of success. That is, the market will follow them and prop up their moves.

I sincerely doubt there are many individual traders out there with a 10 year record of beating market performance by ten percent.

RunDownHouse

05-13-2005, 02:29 PM

There is no "lead steer" in the market, although this theory used to be popular, and still is to some people.

DesertCat

05-13-2005, 07:22 PM

[ QUOTE ]

John Allen Paulos does a great job of laying out many market theory's in his book "A Mathematician Plays the Stock Market." One point that he makes that I have really carried with me since reading it is that many market "gurus" like Buffett, Peter Lynch, or John Neff have an effect on the market and their stock choices can become self-fulfilling after a short-term period of success. That is, the market will follow them and prop up their moves.

[/ QUOTE ]

This is patently false when it comes to Buffett. He wasn't even well known until the 80's but had beat the market almost every year since the mid-50s. Since he's become a "rock star" his level of outperformance has actually declined, but that's primarily due to the enormous size of his portfolio dragging down his returns.

Buffett's success is basic value investing principles, he buys undervalued securities. He's just been at it a bit longer, and is a bit better at it, than all the other value investors.

edtost

05-13-2005, 08:15 PM

[ QUOTE ]
Buffett's success is basic value investing principles, he buys undervalued securities. He's just been at it a bit longer, and is a bit better at it, than all the other value investors.

[/ QUOTE ]

Or undervalued investments are becoming harder to find as the markets become more efficient....

GeorgeF

05-14-2005, 02:45 PM

Market Wizards is talking about a handfull of people, most of which have smallish amount of money ($100,000). Malkeil is talking about large numbers of people and billions of $.

It is impossible for large numbers of people to beat the market.

It is impossible for more than a few large billion dollar funds to beat the market.

Both books agree. The market can be beat by a very small number of people with comparitively small amounts to invest.

eastbay

05-14-2005, 03:21 PM

[ QUOTE ]
Malkeil is talking about large numbers of people and billions of $.

[/ QUOTE ]

I highlighted his language to emphasize that this is not the case. He says, literally, "no one." He does not say "most" or "on average" or "people with little capital." He says "no one."

[ QUOTE ]

Both books agree. The market can be beat by a very small number of people with comparitively small amounts to invest.

[/ QUOTE ]

Small is not the same as no one. The books don't agree.

eastbay

DesertCat

05-14-2005, 06:38 PM

[ QUOTE ]

Or undervalued investments are becoming harder to find as the markets become more efficient....

[/ QUOTE ]

I wonder about this myself. The counter proof is that Buffett is still outperforming the S&P 500 even with his $120B anchor. He does find legit undervalued investments.

I used to think that improving technology might narrow the underpricings but I changed my mind. It doesn't matter how quickly you can find low PE or low P/B stocks, if you don't follow the value investing philosophy. For the market to truly become more efficient, a higher percentage of the money being managed has to be managed intelligently, and I'm not sure I see any evidence of that.

The internet boom is a great counter example as well. There were "momentum investors" (i.e. gamblers) who attracted tons of money when the market went up. And they will again the next time we have a great bull market. It doesn't seem anyone learns any lessons. CNBC isn't helping anyone become better investors, on the contrary it's akin to a "pump and dump" PR service.

But for Buffett to really shine in the future he needs a market crash, like the seventies. He's stuck sitting on his hands right now.

I on the other hand, am a micro investor and I invest in areas where few professionals care to look, so I have no trouble beating the indexes. But I wish I had Buffett's problem.

edtost

05-14-2005, 06:53 PM

[ QUOTE ]
The internet boom is a great counter example as well. There were "momentum investors" (i.e. gamblers) who attracted tons of money when the market went up. And they will again the next time we have a great bull market. It doesn't seem anyone learns any lessons.

[/ QUOTE ]

As Malkiel mentions somewhere in his book, the problem with this kind of thinking is that although the inefficiencies are obvious looking back at the bubble, there was no real way to identify places to short at the time to take advantage of the overvaluations.

DesertCat

05-14-2005, 08:19 PM

[ QUOTE ]

As Malkiel mentions somewhere in his book, the problem with this kind of thinking is that although the inefficiencies are obvious looking back at the bubble, there was no real way to identify places to short at the time to take advantage of the overvaluations.

[/ QUOTE ]

Well there's two sides to that, first is that the inefficiencies were there, proving how inefficient the modern market can still get.

And shorting isn't the province of most value investors. The risk/reward isn't attractive and the Ben Graham school accepts that no matter how out of whack the market gets, no-one has any idea when it will correct. So staying on the sidelines is the best option for the intelligent invester. This is partly why a market bubble can persist for so long and get so extreme.

But there were a couple ways to profit from the internet boom. First occured during the boom, supposedly low growth "old economy" companies suffered from lack of interest and were cheap. I wasn't actively investing then so I can't attest to the truth of this.

But, after the bubble I can attest to the great valuations in the internet market. Internet companies sometimes sold for less than cash, even after announcing the decision to shut down and return all of that cash. That's the standard Ben Graham play, stay in cash during the crazy times, and dive in during the over-correction.

Once again, both episodes show how inefficient the market can get, and why people like Buffett say the market is frequently efficient, but not always.

BadBoyBenny

05-15-2005, 12:49 AM

[ QUOTE ]
Warren Buffett made an interesting comment about trader performance records with his famous "coin flipping contest" argument. ie. Even with millions of participants in a huge tournament someone will still win the tournament. Does that make the winner an expert coin flipper?

[/ QUOTE ]

You need to reread the essay. He makes the exact opposite point. Link (http://www.tilsonfunds.com/superinvestors.html)

[ QUOTE ]
That said, having read both books, and being a portfolio manager by trade, I think that there is a grey area in between the two books. I think it is possible to beat the market (and have consistently done so myself) but like anything else worthwhile, it is fairly difficult to do, is a lot of work, and takes a certain disposition.

[/ QUOTE ]

I agree.

[ QUOTE ]
For most people I think trading is -EV. This is confirmed by the numerous studies on retail trading accounts, mutual fund performance, day-trader failure rates, and even independent floor traders who constitute a hugely motivated and full-time group.

[/ QUOTE ]

Very true once again. I agree with the other posters comparison to poker though. However, just because I think the market can be beat doesn't mean I am willing to bank my retirement on a belief that I can beat it. Although trusting someone who has a proven track record (Bill Miller, etc.) with my retrement doesn't seem like a bad idea.

[ QUOTE ]
In other words, who wants to spend hours a day working on trading when you only have a ~10% chance of beating the market. Of those ~10%, how many beat the market by say double-digits per annum? If not, does the extra 5% a year compensate for the time, training, and stress of just holding the SPY's which if you hold them long enough are an almost sure thing?

[/ QUOTE ]

Yes 5% would be worth it. Lets take an example of 10,000 invested over 30 years.

At 10% - $174494.02
At 15% - $662117.72

that's an oversimplification, but the point is 5% is a big enough edge to make a huge difference. At 1 or 2 percent the opportunity cost of making other income may be greater than the extra returns depending on your professional skills.

RedManPlus

05-16-2005, 12:18 PM

[ QUOTE ]

And yet, on page 245 of "A Random Walk Down Wall Street", Malkiel makes the somewhat astonishing assertion that:

No one person or institution has yet to produce a long-term, consistent record of finding money-making, risk-adjusted individual stock-trading opportunities.

Which do you think is closer to the truth?

eastbay

[/ QUOTE ]

Malkiel is exactly correct about "efficient markets".

Example of "efficient markets":

Large Cap Stocks
Liquid Commodities
All Index/Commodity Futures
Most Option Markets
Mutual Funds
Anything an Unsophisticated Person Would Think of Trading

** No one ** beats these markets long-term...
Without inside information...
Combined with "closeness" to the market...
And rock bottom transaction costs.

But people lie about their results all the time.
(This must be a big shock for poker players).
The hedge fund world is unregulated.
Books like "Market Wizards" are mostly hype.

I'm a professional trader and US broker-dealer..
And have both MW books...
And they were a waste of time and money.

But...
There are many "inefficient markets"...
Such as exotic warrants/convertibles/bonds...
Where a sophisticated "risk arbitrage" can be very profitable.

Please note the words...
"exotic", "sophisticated", "risk", and "very profitable".

Only very special people can do this...
Perhaps max 10% of hedge fund managers...
And precisely ZERO stock brokers...
Just like only a very specially talented person can be a top pro poker player.

rm+

/images/graemlins/cool.gif /images/graemlins/cool.gif /images/graemlins/cool.gif

RedManPlus

05-16-2005, 12:33 PM

[ QUOTE ]
[ QUOTE ]
[ QUOTE ]
Warren Buffett made an interesting comment about trader performance records with his famous "coin flipping contest" argument. ie. Even with millions of participants in a huge tournament someone will still win the tournament. Does that make the winner an expert coin flipper?

[/ QUOTE ]

Obviously not, but I think the analogy is poor.

[

[/ QUOTE ]

I don't think the analogy is that far-off. My experience is that a good portion of the people profiled in the Market Wizards books are the "coin flippers" who got lucky. There are some notable exceptions, including the guy I work for.

[/ QUOTE ]

Buffett and Paluka are correct.
The "coin flipping" analogy is dead on.

The overwhelming majority of mutual funds managers...
That tout "outperforming" the S&P 500...
In other words...
Doing better than MINUS 21% (plus 2% annual dividends)...
Over the last 5 and a half years...
Are just the lucky "coin flippers".

rm+

/images/graemlins/cool.gif /images/graemlins/cool.gif /images/graemlins/cool.gif