Fortune's Formula (15 page)

S
AMUELSON ADOPTED
Bachelier’s ideas into his own thinking. Characteristically, he did everything he could to acquaint people with Bachelier’s genius. Just as characteristically, Samuelson called Bachelier’s views “ridiculous.”

Huh? Samuelson spotted a mistake in Bachelier’s work. Bachelier’s model had failed to consider that stock prices cannot fall below zero.

Were stock price changes described by a conventional random walk, it would be possible for prices to wander below zero, ending up negative. That can’t happen in the real world. Investors are protected by limited liability. No matter what goes wrong with a company, the investors do not end up owing money.

This spoiled Bachelier’s neat model. Samuelson found a simple fix. He suggested that each day, a stock’s price is multiplied by a random factor (like 98 or 105 percent) rather than increased or decreased by a random amount. A stock might, for instance, be just as likely to double in price as to halve in price over a certain time frame. This model, called a log-normal or geometric random walk, prevents stocks from taking on negative values.

To Samuelson, the random walk suggested that the stock market was a glorified casino. If the daily movements of stock prices are as unpredictable as the daily lotto numbers, then maybe people who make fortunes in the market are like people who win lotteries. They are
lucky
, not
smart
. It follows that all the people who advise clients on which stocks to buy are quacks. The favored analogy was, you might as well choose stocks by throwing darts at the financial pages.

This skepticism became formalized as the efficient market hypothesis. It claims that the market is so good at setting fair prices for stocks that no one can achieve better returns on their investment than anyone else, save by sheer luck. University of Chicago economist Eugene Fama developed the idea both theoretically and empirically.

There is much truth in the efficient market hypothesis. The controversy has always been over just how far the claim can be pressed. Asking whether markets are efficient is like asking whether the world is round. The best way to answer depends on the expectations and sophistication of the questioner. If someone is asking whether the world is round
or flat
, as fifteenth-century Europeans might have asked, then “round” is a better answer. If someone knows that and is asking whether the earth is a geometrically perfect sphere, the answer is no.

The stock market is more efficient than many small investors think. Studies show that most actively managed mutual funds do worse than the market indexes. Yet people put money into these funds believing that the fund management must be worth the fees they charge. The more difficult question is whether
some
extremely talented investors can beat the market.

Samuelson claimed an open mind on this. “It is not ordained in heaven, or by the second law of thermodynamics,” he wrote, “that a small group of intelligent and informed investors cannot achieve higher mean portfolio return with lower average variabilities.” Still, Samuelson didn’t see any convincing evidence that such people existed. You might compare his position to that of a present-day “skeptic society” on psychics or UFOs. Samuelson challenged the hotshot money managers to
prove
their superior abilities.

Fama and other economists such as Jack Treynor, William Sharpe, Fischer Black, and Myron Scholes earnestly tried to find investors or investment techniques that really and truly beat the market. It seemed that (like other practitioners of the paranormal) superior portfolio managers had a convenient habit of touting their successes and forgetting their failures. In the majority of cases, claims of beating the market evaporate when subjected to scrutiny.

It is worth spelling out exactly what kind of performance the economists were looking for—and what the efficient market theorists were
not
saying. They were not saying that no one makes money in the market, obviously. Most long-term investors do make a nice return, as well they should—otherwise, why would anyone invest?

Nor were they saying that no one makes better than average returns. “Average” return is measured by indexes like the Dow Jones Industrial Index or the Standard & Poor’s 500. These track the performance of a group of representative stocks. Plenty of investors do better than the indexes, for a few years. A handful do better for decades.

The theorists were not even saying, necessarily, that all the market-beaters are simply lucky. There are ways to boost return by accepting greater risk. One is to use leverage. A very aggressive investor might borrow money to buy more stock than he could otherwise. This multiplies the expected return—and also multiplies the risk.

For these reasons, the notion of a superior investor needs to be carefully qualified. The hallmark has to be a market-beating
risk-adjusted
return, achieved not through luck but through some logical system. It was concrete evidence of this that the economists failed to find.

A name that occurs to many people today is Warren Buffett. “I’d be a bum in the street with a tin cup if the markets were efficient,” Buffett once said. Buffett had already made a name for himself with a successful hedge fund and had founded Omaha-based Berkshire Hathaway when Samuelson wrote that “a loose version of the ‘efficient market’ or ‘random walk’ hypothesis accords with the facts of life.” Samuelson added: “This truth, it must be emphasized, is a truth about New York (and Chicago, and Omaha).”

Samuelson apparently felt that Buffett’s success was best filed with a small minority of “unexplained cases.” Skeptics cannot possibly investigate every claimed psychic, UFO abductee, or market-beating investor. After so many investigations with no proof, a certain cynicism is justified.

Samuelson, however, hedged his personal bets—by putting some of his own money in Berkshire Hathaway.

The claim that the market is efficient is a disturbing one to many people. It is disturbing, most obviously, to the professional stock-pickers who run mutual funds or manage wealthy people’s investments. If the efficient market hypothesis is true, these people provide no useful service.

The dissatisfaction runs beyond Wall Street. Many an American dream entails making more money for less effort in shorter time than the other guy. At the Kefauver hearings, Willie Moretti supplied a telling definition of the word
mob
: “People are mobs that make six percent more on the dollar than anyone else does.”

It is not just criminals who cherish the belief that there is an easier way of getting rich. The small investor has long been inundated by mutual fund and brokerage ads implying that you’d be a sap to settle for “average” returns. It is an American credo that you can pick a “good” mutual fund from Morningstar ratings. “Good” presumably means that it will earn more cents on the dollar than an index fund. It is a more astonishing credo that the small investor can pick market-beating stocks him- or herself just by doing a little research on the Internet and watching pundits on CNBC.

This raises an important point, the connection between market information and return. “In an efficient market,” Eugene Fama wrote, “competition among the many intelligent participants leads to a situation where, at any point in time, actual prices of individual securities already reflect the effect of information based both on events that have already occurred and on events which, as of now, the market expects to take place in the future.”

Fama’s words recall Shannon’s perfect cryptographic system. Ciphers are broken through telltale patterns. Therefore, all codes aspire to the condition of noise. Predictable patterns in the market would allow excess returns. The “competition” of second-guessing the market’s next move effectively erases any such patterns. Hence the random walk and an efficient market no one beats.

Fama did not presume to measure the market’s information in bits, as Kelly did. Information was nonetheless a key feature of Fama’s analysis. In a 1970 article, Fama used information sources to distinguish three versions of the efficient market hypothesis.

Fama’s “weak form” of the hypothesis asserts that you can’t beat the market by predicting a stock’s future prices from knowledge of its past prices. This takes aim at technical analysts, people who look at charts of stock prices and try to spot patterns predictive of future movements. The weak form (in fact,
all
the forms of the efficient market hypothesis) says that technical analysis is worthless.

The “semistrong form” says that you can’t beat the market by using
any
public information whatsoever. Public information includes not only past stock prices but also every press release, balance sheet, Bloomberg wire story, analyst’s report, and pundit comment. No matter how intently you follow the news, and no matter how good you are at drawing conclusions from news, by gut instinct or fancy software, you can’t beat the market. Fundamental analysis (the study of company finances and other business and economic factors) is worthless, too.

Finally, the “strong form” adds private information to the mix. It says that you can’t beat the market
even
if you have access to company news that has not yet been made public. “Insider trading” is worthless!

Fama was not going quite that far. He was just laying out the logical possibilities. There are of course many cases of company insiders profiting from advance knowledge to buy or sell stock. There have also been studies offering evidence that private information leaks into the market and affects prices before public announcements. Insiders may find that the market has already priced in their private knowledge.

The common element to all of Fama’s three versions is the claim that no one has a usable “private wire” on the stock market. There is no way to achieve consistently better-than-market returns.

No one raised criticism of the opposing view to a higher art than Paul Samuelson. His most famous rant, published in the first issue of the
Journal of Portfolio Management
(1974), runs in part:

Through the spirited advocacy of Fama and Samuelson, the efficient market hypothesis swept the academic community in the 1960s and 1970s (a time that happened to be boom years for “star” portfolio managers, actively managed mutual funds, and media coverage of stock investing). Its influence was endorsed by the Nobel Prize committee. Samuelson took home the first economics prize awarded to an American (in 1970), and Fama seems to be on everyone’s short list of likely future Nobelists. A sizable proportion of economics prizes have gone to students and associates of Samuelson’s, who shared his views on market efficiency. The influence, and attitude, of this clique was captured in one nickname: the “Random Walk Cosa Nostra.”

To some it seemed that an MIT “Mafia” made it difficult to publish dissenting views in
The Journal of Finance
and other prestigious publications. In the mid-1980s, MIT information theorist Robert Fano wrote a paper arguing that stock price changes are not exactly a random walk and are subject to predictable cycles. He showed it to some MIT economists for comment. The reaction to the paper’s mere premise was brutal. “Unless you’re working in a certain way, with certain views, you’re wrong,” is how Fano described it. He was told that it would be pointless to seek publication. The referee “would call someone at MIT and they’d say, ‘Oh, yes, he’s a crackpot.’”