Asymmetrical Information

Again, one of the advantages of sports wagering over equity investing is that going long or short on a competitor is equally advantageous; there is a certain date of resolution. Combined with the facts that sports wagerers are more consistently irrational and overconfident in their skills than equity investors, and athletic performance may now be in fact more transparent than corporate performance, the disciplined analyst may do better on Las Vegas Boulevard than Wall Street, if it weren't for the fact that the Nevada market makers will attempt to exclude those who prove to be consistently successful.

Interesting comment, Will, but I don't think that you'll be exclulded if you're too good...that might be true in black jack, when you're betting against the house, but in sports gambling the house just tries to balance the action and then takes a cut. This is also true of pari-mutuel betting, like at a horse track. The big disadvantage of sports betting is that average returns (after the house takes a cut) are negative, where as for the market they're positive.

The article entirely misses the point of efficient market theory. Paradoxically, markets are efficient (you can argue HOW efficient i.e. weak or strong form etc etc) ONLY b/c a lot of people believe they are NOT efficient. That is, competition to find inefficiencies in the market MAKES it more efficient.


Then think about this, if I believe that the market is inefficient and I can exploit this to the tune of abnormal profits defined as more than the long-term average 10% annual return from an index fund --- why would I tell anyone? If they use my ostensibly 'good' information, they compete away my profits. So, think about this next time you watch CNBC et al.

This is one of the reasons I'm a big believer in index funds like the S&P 500 or the Wilshire 3000. (Plug: Vanguard runs efficient funds.) However, I still do some stock picking in hopes of beating the market. To do so, I follow three rules:

1) I must understand the company well enough to know how they can make money, what can cause them to lose money, and what surprises (good/bad) are they susceptible to.
2) I need a plausible argument as to why I understand this better than other active investors (including fund managers), i.e. why am I right and they are wrong?
3) I track the performance of my choices vs. the market indices. If I show a string of relative losses in one market segment, that's the sign that I didn't correctly apply rules #1 and #2, and so I should abandon that segment.

So, when I invest my $X each month (actually $3X after a very profitable recent choice), I try to find an individual stock by my rules, and if I can't find one by about the 10th, I just plunk it into a mix of index funds, trying to move them towards a pre-selected balance. December looks like it's going to be an index-fund month.

Over the years, this has taught me that I understand software, technology service, and a little bit about energy. I don't understand squat about pharmacueticals, banks, or telecommunications. In the meantime, I've beat the markets by about 2-3% a year by riding the crowd when I'm dumb and beating them in the rare cases when I'm smart.

Interesting point about the undervaluation vs overvauation phenomena. But doesn't the growth of hedge funds tend to counter this a bit?

Dan,

Don't quit your day-job.

vlad

ed, that is true for the average, small wagerer. However, if one starts making large, consistently successful bets, particularly close to game time, when there may be difficulty for the house in balancing sides, or laying off with other books, one will be banned eventually. I recently read of a very successful professional horse player, who resides in Las Vegas, who goes to some lengths to conceal that it is his action, since the books don't want his money anymore.

I've wagered on the last 21 Super Bowls, and am 17-4 against the spread. My winnings have been better than this record would indicate, since I took the moneyline on some of the dogs in these contests. This isn't because I am so smart; it is because the Super Bowl attracts so many novice, irrational, and uninformed bettors. If I tried to wager every weekend during the NFL season, I'd be ground into dust.

I agree that shorting stocks has special dangers however what the author missed is taking into consideration the existing positions in a stock. Any company that is traded on a serious exchange has a good chunck of its shares owned by a fund of some type. If a stock is overvalued it can be 'shorted' safely by a 'smart guy' who owns a good number of shares. Also the 'smart guys' who run manage large funds can short a stock they feel is overvalued without the risk carried by a small investor. They can hedge the risk of shorting by using options and other techniques.

Vlad,

I would consider your advice if a) my portfolio performance worried me, or b) you suggested a better strategy.

I have been doing this for ten years and am happy with my track record. I'm not a day-trader, just a reasonably successful individual investor. I apologize for having wasted your time by sharing the strategy that has brought me that success.

Dan: This is one of the reasons I'm a big believer in index funds like the S&P 500 or the Wilshire 3000.

Slight nitpick. You either mean the Russell 3000 or the Wilshire 5000. :)

I follow three rules:

It's more work than I'm willing to do, but as long as you keep a good portion in the index funds (I'd say at least half), I don't see anything wrong with that strategy, especially if it's worked for ten years.

To a non-economist like me it's hard to believe that any market is perfectly efficient, but also hard to believe that any market is perfectly inefficient.

So, various markets have various efficiencies if one designs some figure of merit for efficiency and consistently calculates it for each market.

That said, maybe a good analogy to those who can make better than market average money by trading a market may be that some people can improvise and invent music well "by ear", and others can't.

Both endevors are part science and part art, part careful practice and part born talent, part calculation and part intuition, which of course is often developed by arduous work and practice.

For most of us it's as mystical as Will Roger's dictum, "Making money in the stock market is easy. Just find a stock. Buy it. When it goes up, sell it. If it don't go up, then don't buy it."

Even if one is a believer in index funds, one must still make some strategic decisions. Are you going to invest only in the US markets, or also in foreign markets? If the latter, which ones and how much?

And very importantly, how much are you going to put in stocks, in bonds, and in cash equivalents?

Even if investment in individual stocks were eschewed, I would expect significant variance in the performance of investors/managers based on considerations such as the above.

Those are the same conclusions I've come to about overvaluation and going short. I've had some wonderful short positions over the years - I wish I had a videotape of me trying to dial the phone after seeing an online quote that showed one of my shorted stocks down $45 on the day. But the same lunatics that take a stock from $5 to $50 can take it it to $200, too.

I've been on the receiving end of some of those, and they tend to make one's overall short-selling record a series of nice gains which are swamped by the occasional catastrophic loss.

Any investment strategy that plans to take advantage of human folly has to contend with the fact that folly is in limitless supply.

We managed to break even, including travel and research expenses, on our spell of horse race gambling (not a wholesome trotting race, no, but the kind where the jockey sits right down on the horse). All it takes is the discipline not to bet horses with shorter odds than your probability of being right. If you pick the winner half the time, and pass on any horse at less than three to one, you make money. The favorite typically wins no more than a third of the races.

I've been on the receiving end of some of those, and they tend to make one's overall short-selling record a series of nice gains which are swamped by the occasional catastrophic loss.

Do you think there's a bias in the market because it is cheaper for investors to bet on a long position (that a stock will go up) than it is to bet on it going down?

Interstingly enough, Marc Cuban, internet billioniare and owner of the NBA Dallas Mavericks, says he is starting a sports betting *hedge fund* to clean up all the stupid sports bettors' money.

http://www.scrivener.net/2004/12/marc-cuban-bets-he-can-beat-bookies.html

In other ways he's been pretty smart -- he sure cashed out of the Internet boom on top -- but what he thinks he's doing here has got me puzzled. It'll be fun to watch.

I think that beating the mearket is very possible for several reasons. The biggest reason is that the people who are trying to beat the market professionally, by and large, have a very small set of interests. To be a professional Wall Street type you have to be willing to spend upwards of 70 to 80 hours a week looking at the same data that everyone else is looking at trying to discern some trend that the others aren't seeing. Meanwhile, regular people are off looking at various other pieces of information for fun and profit. This allows them to have a different type of perspective that isn't taken into account by professional stock valuators.

For instance, I probably should have bet on Target a long time ago when the fashionistas I hang out with started talking about it as being a hipper version of Walmart. Do professional stock pickers have time to hang out at coffee shops with hipsters? Probably not. They have to wait for sales data to generate some kind of trend line, long after the initial impulse that generated the line has happened. This is just one example of something that happens every day. Real people have lives, and hobbies, and friends who do interesting things. This may not always lead to good stock tips, but it certainly can. And in the cases where it does, the market is inefficient because it spends too much time looking the same information, and not enough time looking at the broad range of human activity.

Beating the market does not mean that you make a single bet that has a return that's above the market average. It means being able to consistently beat the market's level of return relative to a given level of risk.

All the time people get lucky in the market, the lottery or in casinos. What rarely happens is someone who is able to repeatly beat the market, lottery or the house over the long term.

Boonton wrote:

>Beating the market does not mean that you
> make a single bet that has a return that's
> above the market average. It means being able to
> consistently beat the market's level of return relative
> to a given level of risk.

Accepting that technical definition of "beat the market", it becomes worthwhile to point out that one need not "beat the market" technically to become much better off than the hypothetical "average investor".

For example, if one bought a $10,000 basket of stocks in 1992 that became worth $1,000,000 in 2000, then sold and bought T-bonds. One may or may not have technically "beat the market" on the runup. But one certainly didn't "beat the market" on the downhill slide. One was no longer even "in the market".

But one would be considerably better off than the hypothetical "average investor" who rode the market up, then down.

So, the practical question becomes, which is more important, "beating the market"? Or making money?

From a practical standpoint, technically "beating the market" is reminiscent of the old sports retort, "they outscored us, but we won on statistics."

Will Rogers' observation may be too mystical to apply practically.

But Kenny Rogers offers some insight that might be applied, although limited by the practicality of "knowing":

"You got to know when to hold 'em; know when to fold 'em,
Know when to walk away; know when to run."

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