Beyond the Random Walk

Beyond the Random Walk

It is difference of opinion that makes horse races (Mark Twain, Pudd’nhead Wilson).

Even a dart-throwing chimpanzee can select a portfolio that performs as well as one carefully selected by the experts. This, in essence, is the practical application of the theory of efficient markets. The theory holds that the market appears to adjust so quickly to information about individual stocks and the economy as a whole that no technique of selecting a portfolio – neither technical nor fundamental analysis can consistently outperform a strategy of simply buying and holding a diversified group of securities such as those that make up the popular market averages.

The broad acceptance of this thinking by financial economists and market practitioners became evident as the 1980s progressed. More and more, individual and institutional investors threw in the stock-picking towel and opted for indexing – that os, simply buying and holding one of the broad market indexes such as the Standard & Poor’s 500-Stock Index or perhaps the Wilshire 5,000 Index, an index that contains an additional 4,500 smaller companies. By 1990 literally hundreds of billions of dollars of endowment and pension-fund portfolios were invested in one or more of the market indexes.

But the 1980s also spawned some new doubters about market efficiency and renewed attacks to batter the theory down. With easy access to large-scale computers and with financial and stock price data of all sorts available both to practitioners and to academicians, the search was on to make one’s fortune and/or academic reputation by proving the efficient-market theory wrong. An academic battle of epic proportions was under way as a new generation of financial economists tried to make their reputation (and gain tenure at prestigious universities) by proving their elders wrong.

New York downtown, Battery and Hudson parks. Photo by Elena

And then, in the midst of it all, the stock market crashed with such ferocity that the thundering herd was buried under the debris for months to come. Early in October 1987, the most popular stock-market index in the United States, the Dow Jones average of 30 major industrial corporations, sold at approximately the 2,600. After October 19, a day in which this index fell by over 500 points in unprecedented trading volume, the market traded under the 1,800 level – a drop of approximately one-third within a single month. This is efficient? To many observers, such an event stretches the credibility of the efficient-market theory beyond the breaking point. Did the stock market really accurately reflect all relevant information about individual stocks and the economy when it sold at 2,600 early in October? Had fundamental information about the economic prospects of U.S. Corporations changed that much in the following two weeks to justify a drop in share valuations of almost one-third?

In the view of one influential financial economist, Robert Shiller, stock prices show far “too much variability” to be explained by an efficient-market theory of pricing, and one must look to the behavioral considerations and to crowd psychology to explain the actual process of price determination in the stock market. This view was obviously shared by thousands of investors who left the stock market in disgust. No amount of esoteric academic evidence could convince them that the market was an efficient and hospitable place in which to invest.

We present here an ivy-tower view of the debate and the new evidence uncovered during the 1980s. We will review all the recent research proclaiming the demise of the efficient-market theory. Our conclusion is that such obituaries are greatly exaggerated. We’ll also refer back to the underlying rational model of stock valuation and describe the “fundamental” events that could provide a rational explanation for the October 1987 crash. We will see that while the stock market may not be perfect in its assimilation of knowledge, it does seem to do a quite creditable job.

While we will present all research results in nontechnical terms, the reader should be warned that the material is a bit tougher than was described in previous articles. But don’t skip this chapter. Some of the statistical findings suggest useful investment strategies for individual investors.

Burton G. Malkiel. A Random Walk Down Wall Street, including a life-cycle guide to personal investing. First edition, 1973, by W.W. Norton and company, Inc.