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Since then, my questions about the stock market have hardened into a larger puzzle: a major industry appears to be built largely on an ‘illusion of skill.’ Billions of shares are traded every day, with many people buying each stock and others selling it to them. It is not unusual for more than 100 million shares of a single stock to change hands in one day. Most of the buyers and sellers know that they have the same information; they exchange the stocks primarily because thy have different opinions. The buyers think the price is too low and likely to rise, while the sellers think the price is high and likely to drop. The puzzle is why buyers and sellers alike think that the current price is wrong. What makes them believe they know more about what the price should be than the market does? For most of them, the belief is an illusion.
In its broad outlines, the standard theory of how the stock market works is accepted by all the participants in the industry. Everybody in the investment business has read Burton Malkiel’s wonderful book “A Random Walk Down Wall Street” Malkiel’s central idea is that a stock’s price incorporates all the available knowledge about the value of the company and the best predictions about the future of the stock. If some people believe that the price of a stock will be higher tomorrow, they will buy more of it today. This, in turn, will cause the price to rise. If all assets in a market are correctly priced, no one can expect either to gain or to lose by trading. Perfect prices leave no scope for cleverness, but they also protect fools from their own folly. We now know, however, that the theory is not quite right. Many individuals investors lose consistently by trading, an achievement that a dart-throwing chimp could not match. The first demonstration of this startling conclusion was collected by Terry Odean, a finance professor of UC Berkeley who was once my student.
To determine whether those ideas were well founded, Odean compared the returns of the stock the investor had sold and the stock he had bought in its place, over the course of one year after the transaction. The results were unequivocally bad. On average, the shares that individual traders sold did better than those they bought, by a very substantial margin: 3:2 percentage points per year, above and beyond the significant costs of executing the two trades.
It is important to remember that this is a statement about averages: some individuals did much better, others did much worse. However, it is clear that for the large majority of individuals investors, taking a shower and doing nothing would have been a netter policy than implementing the ideas that come to their minds. Later research by Odean and his colleague Brad Barber supported this conclusion. In a paper titled “Trading I Hazardous to Your Wealth” papers.ssrn.com/sol3/papers.cfm?abstract_id=219228 they showed that men acted on their useless ideas significantly more often than women, and that as a result women achieved better investment results than men.
Although professionals are able to extract a considerable amount of wealth from amateurs, few stock pickers, if any, have the skill needed to beat the market consistently, year after year. Professional investors, including fund manager, fail a basic test of skill: persistent achievement. The diagnostic for the existence of any skill is the consistency of individual differences in achievement. The logic is simple: if individual differences in any one year are due entirely to luck, the ranking of investors and fund will very erratically and the year-to-year correlation will be zero. Where there is skill, however, the ranking will be more stable. The persistence of individual differences is the measure by which we confirm the existence of skill among golfers, car salespeople, orthodontists, or speedy toll collectors on the turnpike.
Mutual funds are run by highly experienced and hardworking professionals who buy and sell stocks to achieve the best possible results for their clients. Nevertheless, the evidence from more than fifty years of research is conclusive: for a large majority of fund managers, the selection of stock is more like rolling dice than like playing poker. Typically at least two out of every three mutual funds underperform the overall market in any given year.
More important, the year-to-year correlation between the outcomes of mutual funds is very small, barely higher than zero. The successful funds in any given year are mostly lucky, they have a good roll of the dice. There is general agreement among researchers that nearly all stock pickers, whether they know it or not – and few of them do – are playing a game of chance. The subjective experience of traders is that they are making sensible educated guesses in a situation of great uncertainty. In highly efficient markets, however, educated guesses are no more accurate than blind guesses ~ Excerpt Pages 212-214
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