a mathematical question re: stockmarket, page-20

re: a mathematical question stockmarket Here is part of an interview with Eugene Fama. It points out the difference between Randomness and efficiency and also the concept of risk. Risk is what the Investor gets rewarded for. Perceived high risk leads to lower prices and hence higher future returns. Perceived low risk leads to higher prices and lower future returns.

If a stock is trending up and that observation lowers peoples risk perception, then the future returns of such a stock will be mean reverting and lower going forward. The opposite with a down trending stock. This works out over time. As Fama says 50% of the time stocks and Mkts will overshoot and the other 50% of the time they will under react. Hence the illusion of TA.

In the fullness of time you are rewarded for accepting risk others wont. The price you pay determines the future return

In the long term Supply is always constrained ,Think of beach front property , it is demand that varies.

To achieve above average returns in My opinion , One need to take advantage of those times when demand is poor and perceived risk is high .

Mkts are predictable, random and efficient all at the same time.





Peter J. Tanous: How did you first get interested in stocks?

Fama: As an undergraduate, I worked for a professor at Tufts University. He had a "Beat the Market" service. He figured out trading rules to beat the market, and they always did!

I beg your pardon?

They always did, in the old data. They never did in the new data [laughter].

I see. Are you saying that when you back-tested the trading rules on the historic data, the rules always worked, but once you applied them to a real trading program, they stopped working?

Right. That's when I became an efficient markets person.

Okay. Let's get into it. You're known for your work on efficient capital markets. In fact, on Wall Street, the phrase "efficient market" is often attributed to you. I believe you and Ken French made the point that stock market returns are, in fact, predictable over time. How does that jibe with the random walk theory?

The efficient market theory and the random walk theory aren't the same thing. The efficient market theory is much more powerful than the random walk theory, which merely postulates that the future price movements can't be predicted from past price movements alone. One extreme version of the efficient market theory says, not only is the market continually adjusting all prices to reflect new information but, for whatever reason, the expected returns—the returns investors require to hold stocks—are constant through time. [For example, we know that, since the '20s, returns on the New York Stock Exchange common stocks have averaged a little over 10% per year.] I don't believe that. Economically, there is no reason why the expected return on the stock market has to be the same through time. It could be higher in bad times if people become more risk-averse; it could be lower in good times when people become less risk-averse.

So risk is the component that leads to how much you get paid?

It could be just taste, too, you know. People's taste for holding stocks can change with time. None of that is inconsistent with market efficiency and it can give rise to some predictability in returns. The predictability is simply based on the returns people require to hold securities.

But, in one of your papers, you did refer to the predictability of returns over time. Is that just the investor getting paid for the risk he was willing to take? Is that the point?

It could be that or it could be that people are simply more risk-averse in bad times.

Another question that comes up frequently is if markets are correctly priced, how do you explain crashes when they go down twenty percent in one day?

Take your example of growth stocks. If their prospects don't go as well as expected, then there will be a big decline. The same thing can happen for the market as a whole. It can also be a mistake. I think the crash in '87 was a mistake.

But if '87 was a mistake, doesn't that suggest that there are moments in time when markets are not efficiently priced?

Well, no. Take the previous crash in 1929. That one wasn't big enough. So you have two crashes. One was too big [1987] and one was too small [1929]!

But in an efficient market context, how are these crashes accounted for in terms of "correct pricing"? I mean, if the market was correctly priced on Friday, why did we need a crash on Monday?

That's why I gave the example of two crashes. Half the time, the crashes should be too little, and half the time they should be too big.

That's not doing it for me. What am I missing?

Think of a distribution of errors. Unpredictable economic outcomes generate price changes. The distribution is around a mean—the expected return that people require to hold stocks. Now that distribution, in fact, has fat tails. That means that big pluses and big minuses are much more frequent than they are under a normal distribution. So we observe crashes way too frequently, but as long as they are half the time under-reactions and half the time over-reactions, there is nothing inefficient about it.