Stock Market 5 PDF

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Stock Market Essay Intro 3...

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I assume that you have read the last essay and know that in an efficient market only new information can change demand and supply and thereby the price. Now, what are the implications of this result? First off, new information will be positive half of the time and negative half of the time. Because stock prices change as a result of new information, the point that new information is positive 50% of the time and negative 50% of the time means that anytime stock’s price changes, there is a 50% chance it will rise and a 50% chance it will fall. With this 50/50 chance of a rise or fall, stock prices are said to follow a “random walk.” To fix the idea of a random walk, think about someone who has too much to drink and is staggering along the road. Each additional step has a 50% chance of staggering to the left and a 50% chance of staggering to the right. This person’s path is a random walk. The idea of a random walk means whether the price of a stock will rise or fall is a 50/50 chance at any time. In other words, if the price rose last time there is still exactly a 50% chance it will rise next time. So, too, if it fell last time: There is still a 50% chance it will rise this time. Stock price changes are essentially like random coin tosses. Randomly toss a coin and 50% of the times it will land heads and 50% of the time it will land tails. As long as the coin is fair, just because the coin landed heads the last time (or even the last 30 times) on the next throw there is still exactly a 50% chance of it coming up heads. Changes in stock prices work the same way: At any given time, there is a 50% chance the price will rise and a 50% chance it will fall. Just because the price rose the last time (or even the last 30 times!) when it changes again there is still exactly a 50% chance of it rising some more. I hasten to add that even though the price changes are random, the price itself is not random: A stock with higher expected future profits will have a higher price than a stock with lower expected future profits because when the profit was first expected to move higher, the stock price responded to the new information and rose. The result that stock price changes are random means that there are no patterns in how a stock’s price changes from one moment to the next. This result flies in the face of what is called “technical analysis,” which tries to forecast future price changes from past price changes. Technical analysis is popular among various stock market commentators. The notion is that past changes in stock prices can predict future changes. You perhaps have read some of this analysis if you read commentators talking about “support levels,” which are levels through which a price is unlikely to fall but if it does, is then likely to quickly fall to a significantly lower level. Or perhaps you have heard commentators taking about “50-day moving averages” (which calculates the average of a company’s stock price using the last 50 days worth of data so that when each day passes, the 50 days worth of data moves ahead by a day) with the idea that if a stock rises above its 50-day moving average it will rise some more or if it falls below its 50-day moving average it will fall some more. Research shows that these concepts are generally meaningless; that is, there is no such thing as a support level and whether a stock price is above or below its 50-day moving average has no effect on its future price changes. With extremely few exceptions, anyone who tries to tell you that they can predict how a stock price will change based on its past changes is trying to sell you something you ought not to buy! (One of the very few exceptions is that research suggests that stock prices seem to slightly over-react to extremely good news or extremely bad news. That is, if extremely

bad news arrives, a stock’s price moves sharply lower and then, after a day or so, the price tends to rise back a bit. So in this case it looks like you could predict the rise after the big fall and perhaps profit by buying stocks whose prices have sharply fallen. But these changes are small, not totally consistent, and apparently impossible to profit from once the costs of buying the stock are taken into account.) The fact that the stock market is an efficient market also means that it will be impossible for the average investor to predict consistently whether stock prices will rise or fall. Yes, some people apparently can somewhat predict whether a stock’s price will rise or fall but these people are extremely rare—they have to be much better and faster at processing information than the literally millions of other investors who are seeing the same information and trying to make the same predictions as to whether the stock price will rise or fall. Evidence of the fact that the average investor cannot accurately forecast future stock price changes is obtained by looking at the performance of mutual funds. Recall that a mutual fund is an investment vehicle in which many individual savers allow professional investors to make decisions about what stocks to buy. It turns out that on the average, on an annual basis about 2/3 of mutual funds under-perform the stock market as a whole; that is, in any given year, about 2/3 of mutual funds earn less than the average return in the stock market. Mutual funds under-perform the stock market’s average because mutual funds have expenses—such as the salaries of the people who manage them—that subtract from the mutual fund’s performance. Without these expenses, the average mutual fund would do about as well as the market average. With them, the average mutual fund does poorer than the market average. What about the 1/3 of mutual funds that manage to be better than the market average in one year? Are these managers of these funds able to predict whether a stock’s price will rise or fall? It turns out they are not. The 1/3 of mutual funds that out-perform the market are fairly random—they are not the same 1/3 that did better than the previous year. In much the same way that you might occasionally flip a coin and correctly call 5 flips in a row, so too is it the case that in any given year, some mutual fund mangers will (randomly) select stocks that do better than the average. But, just as the odds favor that after 5 accurate calls in a row, on the next flip you have only a 50/50 chance of getting it right, so too is it the case that in the year after they exceed the stock market average, these mutual funds have about a 2/3 chance of falling short the next year. So, what do we make of this evidence? Quite simply, even though mutual funds are run by highly educated, highly talented people who devote most of their waking hours to making accurate forecasts of future stock prices, they are unable to do so. The reason they are unable to do so is because the stock market is an efficient market: It quickly and accurately embodies all known information into prices so that future price changes are an unpredictable random walk. Well, I expect and hope that there is one last question you till have about the stock market: What does all this mean to me and my savings? Well, I plan to answer this very important question in my next essay, STOCK MARKET 6, which I hope to have written and posted relatively soon....