Financial Paradox

Financial Paradox - Some Reflections

Today, closed-end funds are no longer an especially attractive investment opportunity. They illustrate however an important paradox about investment advice, as well as the maxim that true values do eventually prevail in the market. There is a fundamental paradox about the usefulness of investment advice concerning specific securities. If the advice reaches enough people and they act on it, knowledge of the advice destroys its usefulness. If everyone knows about a "good buy" and they rush in to buy, the price of the "good buy" will rise until it is no longer particularly attractive for investment. Indeed, there will be pressure on the price to rise as long as it is still a good buy.

This is the main logical pillar on which the efficient-market theory rests. If the spread of news is unimpeded, prices will react quickly so that they reflect all that is known about the particular situation. This led us to predict that such favorable discounts would not always be available, and we would be very surprised to see the levels of discounts perpetuate themselves indefinitely. For the same reason we are skeptical that very simple currently popular rules such as "buy low P/E stocks" or "buy small company stocks" will perpetually produce unusually high risk-adjusted returns.

There is a well-known academic story about the random walk of a finance professor and two of his students. The finance professor, a proponent of the strongest form of the random-walk theory, was convinced that markets were always perfectly efficient. When he and the students spotted a $10 bill lying on the street, he told them to ignore it. "If it was really a $10 bill," he reasoned out loud, "someone would have already picked it up." Fortunately, the students were skeptical, not only of Wall Street professionals, but also of learned professors, and so they picked up the money.

Montreal, Old Port, random-walkers... Photo by Elena.

Clearly, there is considerable logic to the finance professor's position. In markets where intelligent people are searching for value, it is unlikely that people will perpetually leave $10 bills around ready for the taking. But history tells us that unexploited opportunities do exist from time to time, as do periods of speculative excess pricing. We know of Dutchmen paying astronomical prices for tulip bulbs, of Englishmen splurging on the most improbable bubbles, and of modern institutional fund managers who convinced themselves that some stocks were so "nifty" that any price was reasonable. And while investors were building castles in the air, real fundamental investment opportunities such as closed-end funds were passed by.

Yet eventually excessive valuations were corrected and eventually investors did snatch up the bargain closed-end funds. Perhaps the finance professor's advice should have been, "You had better pick the $10 bill up quickly because if it's really there, someone else will surely take it." It is in this sense that we must consider ourselves random walkers. We are convinced that true value will out, but from time to time it doesn't surprise that anomalies do exist. There may be some $10 bills around at times and we should certainly interrupt our random walk to purposefully stoop and pick them up.

It is clear that the ability to beat the average consistently is very rare. Neither fundamental analysis of a stock's firm foundation of value not technical analysis of the market's propensity for building castles in the air can produce reliable superior results. Even the pros must hide their heads in shame when they compare their results with those obtained by the dart-board method of picking stocks. The only way to achieve above-average returns in an efficient market is to assume greater risk. But risk is far from a simple concept and neither beta no any other single risk measure is likely to be adequate.

Sensible investment policies for individuals must then be developed in two steps. First, it is crucially important to understand the risk-return trade-offs that are available and to tailor your choice of securities to your temperament and requirements. Most investors will not be convinced however, that the random-walk theory is valid. Telling an investor that there is no hope of beating the averages is like telling a six-year-old there is no Santa Claus. It takes the zing out of life.

High Park's blues sakura flowers. Photo by Elena.

For those incurably smitten with the speculative bug, who insist on picking individual stocks in an attempt to beat the market, we can offer some rules. The odds are really stacked against you, but you may just get lucky and win big. We also suggest that you might want to place your bets on the few rare investment managers who, at least in the past, have shown some talent for finding those rare $10 bills lying around in the marketplace.

Investing is a bit like lovemaking. Ultimately it is really an art requiring a certain talent and the presence of a mysterious force called luck. Indeed, luck may by 99 percent responsible for the success of the very few people who have beaten the averages. "Although men flatter themselves with their great actions," La Rochefoucauld wrote, "they are not so often the result of great design as of chance."

The game of investing is like lovemaking in another important respect, too. It's much too much fun to give up. If you have the talent to recognize stocks that have good value, and the art to recognize a story that will catch the fancy of others, it's a great feeling to see the market vindicate you. Even if you are not so lucky, strict rules will help you limit your risks and avoid much of the pain that is sometimes involved in the playing. If you know you will either win or at least not lose too much, you will be able to play the game with more satisfaction. At the very least, we hope these recommendations make the game all the more enjoyable.