Tuesday, November 20, 2012

Punctuated Equilibrium

“In finance, the efficient-market hypothesis (EMH) asserts that financial markets are "informationally efficient". In consequence of this, one cannot consistently achieve returns in excess of average market returns on a risk-adjusted basis, given the information available at the time the investment is made.”

This theory is often presented in books encouraging individual investors to stick with low cost index funds rather than attempting to invest in individual stocks, since there is plenty of information demonstrating that even the best investors seldom beat the averages over a long period of time.

“A random walk is a mathematical formalization of a path that consists of a succession of random steps. For example, the path traced by a molecule as it travels in a liquid or a gas, the search path of a foraging animal, the price of a fluctuating stock and the financial status of a gambler can all be modeled as random walks, although they may not be truly random in reality.”

This is another variation on the notion of an EMH. In this theory a given market or individual stock has a “true” value. However, the instantaneous value of such an investment will fluctuate in a random walk about this “true” value.

I have always had my doubts about efficient market pricing. Insider information can lead to large discrepancies between the perceived value of a stock and its actual value. More recently, scholarly studies have attacked this notion on psychological grounds. Bubbles are not rational. In hindsight it was pretty obvious that the real estate bubble could not continue forever. Could a condo in Florida that sold for $50,000 in 2000 really be worth $600,000 in 2006? Could this rising price trajectory continue into the future? The answer to both questions was, NO! Today that condo might sell at somewhere between $50,000 and $100,000 if a buyer can be located who wants to risk living in a mostly deserted building.

In the Intelligent Investor, Benjamin Graham, the father of value investing differentiates between two functions of the market. He observes that, “In the short term, the stock market behaves like a voting machine, but in the long term it acts like a weighing machine.” Traders buy and sell on short term action, the random walk and short term trends. Investors buy what they believe to be value for the long run, ignoring daily fluctuations in pricing. It can be statistically demonstrated that long term thinking tends to reduce risk, but both methods work. The value investor believes that through research an investor can locate bargains that due to the instantaneous psychological balance between fear and greed represent a sound basis for a long term investment.

I would like to propose a new term to describe market behavior, punctuated equilibrium. This term is actually cribbed from evolutionary biology.

“Punctuated equilibrium (also called punctuated equilibria) is a theory in evolutionary biology which proposes that most species will exhibit little net evolutionary change for most of their geological history, remaining in an extended state called stasis. When significant evolutionary change occurs, the theory proposes that it is generally restricted to rare and geologically rapid events of branching speciation called cladogenesis. Cladogenesis is the process by which a species splits into two distinct species, rather than one species gradually transforming into another.”

More recent studies supporting punctuated equilibrium attack Darwin’s original theory of “gradualism,” the notion that evolutionary change occurs gradually over geologic time. The opponents of Darwin point out there is simply not enough evidence in the fossil record to support gradualism. That is, there are no intermediate species.

The instantaneous price of a share of stock represents its true market value at a moment in time, nothing more. The combined wisdom of millions of investors around the world has agreed on that price. However, that price will fluctuate over time both in short term “random walks” and in longer term trends. It has been demonstrated that most price movements in the stock market happen over relatively short time periods, in some cases in a single day or even a matter of hours. Psychological stresses build up in the investment community over time leading to discrepancies between the perceived and “real” value of a security. Then something happens that leads to a rapid correction up or down to a new equilibrium price.

So what are the takeaways? I have concluded that I can’t predict the future. I don’t even expect that I am smart enough to beat the S&P 500 or any of the major index averages on a regular basis. Since I don’t know on what days the market will jump 200 points or even 500 points, I will be in the market at all times. I believe that for someone of my age (61), I should have somewhere between 40% and 55% of my net worth excluding real estate in a widely diversified portfolio of stocks and the rest in bond funds and cash. When I believe the market is overvalued I will tend towards the lower end of that range and when the market has tanked I will move towards the higher end of that range, but I will maintain this discipline, frequently reminding myself I can not predict the future.

It is my desire to be satisfied so long as my net worth continues to outpace inflation and taxes while I am still working and doesn’t decline so fast after I retire that I will face poverty before I die.

Proverbs 30:

8) Remove falsehood and lies far from me;
Give me neither poverty nor riches—
Feed me with the food allotted to me;
9)Lest I be full and deny You,
And say, “Who is the LORD?”
Or lest I be poor and steal,
And profane the name of my God.

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