Wednesday, February 23, 2011

The Efficient-Market Hypothesis

I have long known I am the luckiest person I have ever met.  Born prematurely, my size was such that others said, in those days, I was lucky to survive.  I have been granted the gifts of intelligence, great health, and various aptitudes.  I have survived car and bus crashes without a scratch when others were not so fortunate.  I also have the good fortune of living in a country filled with opportunity and, very often, with great kindness.  

As I have grown wiser, I no longer choose to call it luck.  Rather, my spiritual journey has taught me to see what I once thought of as being lucky as being blessed, instead.  I believe I live in a state of grace.  It so happens that Grace was also the name of the hospital in which I was born.

In that context, it particularly makes me smile when people tell me how lucky I am, or how much risk I must be taking in order to outperform the market.  You see that is not supposed to be possible.  According to the efficient-market hypothesis it is impossible to consistently achieve returns greater than the market average.  The theory states that the current price of any stock in the market is based on all of the information related to it and is, therefore, the correct price.  As such, a stock can never be under priced, or overpriced.  Given the technology of our day, I would suggest that if the theory ever was correct, it should be even more so at this time (reduced delays, better information, better distribution of information). 

We know that during a bull market phase, the price of the stock tends to be found above its 200-day moving average.  On average a decline of 20 percent or more in the stock markets starts after just about four years from the end of the previous decline of 20 percent or more and lasts for about one and one half years.  During these periods of decline, the price tends to be found below its 200-day moving average.

If I use the 200-day moving average as the point at which to buy and sell (depending on direction), I end up buying at a lower price (the 200-day moving average is lower the longer the price is lower) and selling at a higher price (the 200-day moving average is higher the longer the price is higher).  On average, using this approach, I should really outperform the market every five, or six years.

Of course that makes no sense to the efficient-market hypothesis, because the price doesn`t move higher or lower, it always reflects whatever the price should be.  It could be a gazillion dollars one day, fifty the next, and several thousand the next.  The price is, well, the price!  Interesting theory!

As a result, no matter how long I outperform the market with my returns, the efficient-market hypothesis suggests that since I cannot consistently outperform the market, luck is the only other possible explanation for doing so.  Without knowing much else about me, people must think I am the luckiest person alive.  I just want them to know that, personally, I feel I am much more blessed than I am lucky.  Call it what you will,  I guess I`d still rather be lucky than smart like those academics who can`t understand how, according to their models, it is even possible that anyone can outperform the market.       

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