Friday, May 06, 2005

Market Efficiency - Is He Good, or Is He Lucky? (From VoluntaryXchange)

David Tufte at VoluntaryXchange has a good piece on market efficiency. It deals with the question, "If a money manager has beat the market over the last N years, how likely is it that he was good, vs. how likely is it that he was lucky?"

A theorem of "folk finance" is that it is easy to beat the return of an asset market. A corrollary is that an investor can be informed by paying attention to claims made by others that they have in fact done this.

This is nonsense. Nonetheless it is a fairly popular belief.

Mahalanobis summarizes a paper that looks at this. Understanding the body of the post probably requires some Ph.D. finance classes, so let me translate.

The example at the bottom of the page is built around a hypothetical manager who can consistently beat the market by 3% (that would be an enormous advantage, and it isn't at all clear that anyone has ever done that well). Yet, you can only be 65% sure that this manager will beat the market over the next 25 years.

How is this so? The reason is that the volatility of the market and individual portfolios is so large that one lucky or unlucky year is enough to screw things up.

What does this mean for the casual investor who may pay attention to advertisements that claim that such-and-such a manager has beaten the market for (say) the last 5 years? It means that the odds are 51/49 or so that this manager is above average. On the bright side, this is a bit better than the 50/50 chance that any manager you find in the yellow pages (or even with a poster stapled to a telephone pole) is above average.

P.S. This economist-who-does-finance-too's inside view is that a big difference between economics and finance Ph.D.'s is that the former accept that they can't beat the market, and the latter think that no one but them can beat the market.

Click here for the whole article.

I agree that some finance Ph.D.s seem to believe that market efficiency doesn't apply to them. However, it's not limited to them. A few years ago, I had a colleague (finance prof) tell me that I should buy Enron, because it was selling at $5 (off from its 52-week high of $50). Just last year, I had a lengthy conversation with an accounting prof who was convinced that she could pick stocks by reading the footnotes in the annual report carefully.

It reminds me of the story (probably apocryphal) that 7 out of 10 Americans believe that they're above average drivers. For guys, it's 8 out of 10.

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