Can a blindfolded chimpanzee outperform professional fund managers?

The ‘random walk’ theory, popularized by economist, writer, and Princeton professor Burton Malkiel in 1973 in his book ‘A Random Walk Down Wall Street’, has been cause for debate amongst the most intelligent minds and critical thinkers in the world of finance. 

The random walk theory is based on what is called the Efficient Market Hypothesis. Its apologists state that short-run changes in stock prices cannot be predicted. The efficient market hypothesis says that the marketplace does an outstanding job of aggregating available information (even if it is not universally available) and impounding it instantly into securities’ prices. This seemingly harmless statement translates into an obscene insult on Wall Street,   claiming that investment advisory services, with their comprehensive research into which stocks to trade and their complicated charts, are — simply put — useless at outperforming the market. According to the author, a portfolio created by a blindfolded chimpanzee who is instructed to throw darts randomly at a newspaper stock listing could perform just about as well as a fund actively managed by professionals. 

Formally, there are three versions of the efficient market hypothesis: weak form, semi-strong form, and strong form. All support the notion that while there might be a general long term trend of a security in a particular direction, short-run future price changes are nearly impossible to predict. 

The weak form argues that a security’s current price contains information from past stock price changes, so one cannot predict future prices on the basis of the past. The semi-strong form builds on this, adding that today’s price already reflects relevant information that was made public today. The strong form takes the idea to the extreme, arguing that no new information about a security (even if not publicly released) can be used to predict prices. This is often disregarded, as then there would be no incentive for insider trading to occur – which we know is not the case in reality. 

While bold – outlandish, even – it is well worth our time to analyse the credibility of the efficient market hypothesis and its applications to finance.

On one side, we have market professionals who relentlessly endeavour to make accurate predictions regarding short-run stock price movements. Professionals, often found on Wall Street and its international counterparts, believe that successful fund managers are those who can strategically pick stocks to create a portfolio that can outperform the market. What this means is that their fund would be able to yield higher returns than a fund or portfolio that simply replicates all the stocks present in a large index (e.g. S&P500, or Dow Jones), in their correct proportions. 

There are 2 pillars that uphold their work: technical analysis, and fundamental analysis.

Technical analysis involves making and interpreting charts. Chartists (a self-explanatory profession, in this case) study the movement of stocks in the past, and the volume of trading, for some enlightenment with regards to future direction. Their strategy is to pinpoint the right time to buy and sell. To win the game, you need to figure out how other players are behaving.  Since their research only tells us about players’ past performance, their entire careers depend on the hope that their analyses of the past can shed some light on the future. 

The other foundation of professionals’ work is fundamental analysis. Almost completely contrary to technical analysis, fundamentalists do not care for the pattern of past stock price movements, but rather try to investigate the expected growth rate of companies’ value. Value comes in the form of earnings, dividends, and risk. By doing so, fundamentalists believe they can estimate the intrinsic value of a company-issued security. If its intrinsic value is above current market prices (ie. the security is undervalued in the market), then one is advised to buy. The constant and high volume of trading of securities is believed, in the long run, to eventually adjust market prices to accurately reflect the true value of the security. 

In his book, Burton Malkiel highlights a number of points using the efficient market hypothesis that undermine the integrity of the aforementioned pillars. 

Weak-form market efficiency is used to refute the usefulness of technical analysis. By suggesting that today’s stock price already reflects all the data of past stock prices, drawing up charts that visually demonstrate past performance and movement is shown to be of no value because this information is already accounted for. 

Malkiel further argues that the semi-strong form debunks fundamental analysis. Due to the fact that current information about the market (in the public domain) is accounted for in current stock prices, it is practically impossible for investors to identify undervalued securities and buy them. If information alludes to the fact that a security is undervalued, the active and high-volume nature of the liquid markets we see today means that this data is easily accessible to everyone. Therefore, if as an investor you have an instinctual response to buy low, everyone else with the same information will have the same instinct, and demand for the security rises immediately — raising its price and correcting discrepancies between market value and its intrinsic value. The high volume of trades will almost instantaneously correct any inefficiencies (ie. any under/over-valuations). 

Technically, Malkiel’s arguments only hold if the efficient market hypothesis is indeed true. Why might we expect it to be, then?

One way to assess whether the market truly is efficient is to look back at past events and see if, and how long it took, for market prices to reflect these events. 

If we were to look at the stock market activity on the fateful day of 9/11, we would be able to see just how well the market adjusts to reflect newly available information. Below is a brief timeline:

08:46:10 AM

The first airplane hit the World Trade Centre. 

For the first minute after that, the market had no reaction that reflected this event. 

08:47:28 AM 

The S&P500 index starts to fall. 

It took only a minute for market prices to account for the event that occurred at 08:46:10 am. 

This was before local news channels reported the incident; the first report only came at 08:48 AM. 

Though not immediate, the market’s reaction was faster than the news.

08:49:34 AM

CNN reports the incident. The market does not fall further after this report, as it has already taken into account what had happened. This is evidence of market efficiency. 

09:03:02 AM

The second airplane hit. 

The market collapsed IMMEDIATELY.

The market reacted so quickly this time around because the world trade centre was being filmed live on TV by news channels. Information was readily available to everyone, and it was evident that this was not an accident, but an attack. 

This is just one instance of the market proving to be efficient, by reflecting new events even before news channels did. 

Regardless of whether you choose to believe in the efficient market hypothesis and Burton Malkiel’s Random Walk theory, there are a few indisputably correct takeaways from the example of what happened in the market on 9/11. 

The first is to have respect for the market prices. While there are a number of anomalies that may puzzle advocates of market efficiency (you can read more about that in Malkiel’s book), it is more likely than not that a reported price of a security is its correct value, and while the market may not be consistently perfect, it goes without saying that the market is smart

Another lesson is to be skeptical of easily conjured predictions of stock prices, like those presented by chartists and their technical analyses. Market prices are not easy to predict, so if a chart simply dictates the direction of future prices, it is likely too good to be true. 

Malkiel professes that investing is fun; ‘it’s fun to pit your intellect against that of the vast investment community and to find yourself rewarded with an increase in assets’, he writes.

For that reason alone, his book stands undefeated as a handbook for those just getting acquainted with investing.

This Post Has 2 Comments

  1. Mohammed Elnahwy

    This is by far the most down-to-earth article that provides a good insight on the market analysis. I believe I am not very familiar with the market, but nonetheless, this gave a good understanding of the topic! I am pleased I have come across this and read your article! It kept my interest throughout and provided great information and understanding.

    Thank you!

  2. Ramakanth Das

    Loved the article looking forward for a great future in quant .

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