Monday, April 30, 2012

Louis Bachelier - Random Thoughts (2)


The Efficient Market Hypothesis ("EMH") was developed in the 1960s by a University of Chicago economist, Professor Eugene F. Fama.  Although Fama first coined the term Random Walk, our old friend, Professor Burton G. Malkiel, brought it into the popular consciousness with his first edition of A Random Walk Down Wall Street.  Some attribute the concept to a French broker, Jules Regnault, who wrote about the randomness of stock prices in 1863.  The more recent theory of random prices is based on a doctoral thesis written by a French mathematician, Louis Bachelier, in 1900 entitled The Theory of SpeculationThe basic concept of EMH is that financial markets, at any given point, set a price for a stock with such a degree of speed and efficiency that no investor can earn more from his or her investing strategy than the average market return.

Bachelier wrote the following about market movements:

Past, present, and even discounted future events are reflected in market price, but often show no apparent relation to price changes.....[A]rtificial causes also intervene: the Exchange reacts on itself, and the current fluctuation is a function, not only of the previous fluctuations, but also of the current state.  The determination of these fluctuations depends on an infinite number of factors; it is, therefore, impossible to aspire to mathematical predictions of it....[T]he dynamics of the Exchange will never be an exact science. *

Peter L. Berstein was an economist, university educator, investment manager and famous author of financial history.  In his 1992 book, Capital Ideas / The Improbable Origins of Modern Wall Street, Peter L. Berstein had the following to say about Bachelier:

The key to Bachelier's insight is his observation, expressed in a notably modern manner, that "contradictory opinions concerning [market] changes diverge so much that at the same instant buyers believe in a price increase and sellers believe in a price decrease."  Convinced that there is no basis for believing that - on the average - either sellers or buyers consistently know any more about the future than the other, he arrived at an astonishing conjecture: "It seems that the market, the aggregate of speculators, at a given instant, can believe in neither a market rise nor a market fall, since, for each quoted price, there are as many buyer as sellers." **
(Author's emphasis in bold)

Bachelier followed his thesis to its logical conclusion: the probability of a price rise is the same as the probability of a price decline at any given moment in time.  He stated, "Clearly the price considered most likely by the market is the true current price: if the market judged otherwise, it would quote not this price, but another price higher or lower." *

Bachelier studied the degree of fluctuation in stock prices and constructed a set of mathematical equations which demonstrated that the variations in price are proportional to the length of time in which those variations occur.  His equations resulted in the finding that the range of fluctuations (up or down) was linked to the square root of the time interval of the fluctuations.

In his book, Berstein points out that the stock price variations over time shown by Bachelier's equations are eerily similar to the action of molecules crashing into each other, which is known in physics as Brownian motion, which played a role in Albert Einstein's theories about the atom.

It is, indeed, humbling to consider the similarity between the prices generated by actions of investors in the market and the movement of molecules in nature.  We will continue looking into Random Walk in the next blog.

Quotations from Louis Bachelier's 1900 doctoral thesis, The Theory of Speculation, are contained in Capital Ideas / The Improbable  Origins of Modern Wall Street by Peter L. Bernstein.

**  Excerpts from Capital Ideas / The Improbable  Origins of Modern Wall Street, Peter L. Bernstein, copyright 1992, published by The Free Press, a division of Macmillan, Inc.  A new edition of the book was published in 2005 by John Wiley & Sons, Inc.

Comments are always welcome.


Monday, April 23, 2012

Random Thoughts (1)


Having completed our studies of fundamental and technical investment analysis, we turn our attention to the Random Walk investment theory.  We have read the comments of its most famous proponent, Professor Burton G Malkiel, in past blogs.  However, I want to start this discussion with a passage from Professor Stephen Jay Gould, a paleontologist and essayist, who wrote extensively about paleontology, evolution and the history of science.

Professor Gould, who passed away in 2002, wrote monthly essays in the Natural History magazine which were then put together and reprinted as books.  In one of those books, Full House, The Spread of Excellence from Plato to Darwin, he discussed, among many other things, how humans cope with trends and randomness in life, which he then extended to the stock market as follows:

The more important the subject and the closer it cuts to the bone of our hopes and needs, the more we are likely to err in establishing a framework for analysis.  We are story-telling creatures, products of history ourselves.  We are fascinated by trends, in part because they tell stories by the basic device of imparting directionality to time, in part because they so often support a moral dimension to a sequence of events; a cause to bewail as something goes to pot, or to highlight as a rare beacon of hope.

As one final example, probably more intellectual energy has been invested in discovering (and exploiting) trends in the stock market than in any other subject - for the obvious reason that the stakes are so high, as measured in the currency of our culture.  The fact that no one has ever come close to finding a consistent way to beat the system - despite intense efforts by some of the smartest people in the world - probably indicates that such causal trends do not exist, and that the sequences are effectively random.

His characterization of people and their love of stories is basically the same as that of Professor Robert J. Shiller, which I shared in an earlier blog

I want to paraphrase the most persuasive argument for market randomness I have ever read.  Assume you have assembled 5,000 people for a reality TV show, which you will call "The Flip".  With Hollywood hype and build up, you flip a coin and each contestant presses a button for either heads or tails.  Like the NCAA basketball championship ("March Madness"), this is a "win or go home" competition.  Each week, after the flip (which is obviously random), the people who call wrong leave the program.  The process continues; and, sooner or later, a handful of survivors will have made a surprising, seemingly skillful, string of correct calls.  They may gain some sort of notoriety and celebrity status in the popular media, which you would hope for as the producer of the program.  As these things go, sooner or later, there is only one person left - the winner.  Does that individual indeed possess some innate talent for calling coin flips?  Conversely,  is it just luck and the fact that someone will win, given the rules?  Much is made of winning streaks of every sort in popular culture.  What if it is all due to chance and luck?

We will continue our look at the Random Walk theory in the next blog.

Excerpt from Full House, The Spread of Excellence from Plato to Darwin by Stephen Jay Gould, copyright 1996, Three Rivers Press, pages 30-32.

Comments are always welcome.

Monday, April 16, 2012

Got Game?


What are the traits of an investor or a trader of securities?  What type of person devotes his or her time to this activity?  What is the attraction?  

Jesse Livermore's description of his trading philosophy bears repeating: "Years of practice at the game, of constant study, of always remembering, enable the trader to act on the instant when the unexpected happens as well as when the expected comes to pass." *   In a previous blog, we looked at comments from Professors Malkiel and Keynes about the "game" nature of investing.  Financial writer George J.W. Goodman adopted the pseudonym Adam Smith when he wrote The Money Game in 1967.  Although we have seen it before, his description of the "game" aspects of Wall Street should also be repeated:

Game?  Game? Why did the Master (speaking of Keynes) say Game?  He could have said business or profession or occupation or what have you.  What is a Game?  It is "sport, play, frolic, or fun"; "a scheme or art employed in the pursuit of an object  or purpose"; "a contest, conducted according to set rules, for amusement or recreation or winning a stake."  Does that sound like Owning a Share of American Industry?  Participating in the Long-Term Growth of the American Economy?  No, but it sounds like the stock market.

Smith went on to briefly describe game theory, the mathematical study of actions in a multiple option conflict system (what Smith called the Game), which was developed by John von Neumann and Oskar Morgenstern and published in 1944 in their seminal work, A Theory of Games and Economic Behavior.  He then returned to his characterization of the market's denizens as follows:

I bring this up only because I think the market is both a game and a Game, i.e., both sport, frolic, fun, and play, and a subject for continuously measurable options.  If it is a game, then we can relieve ourselves of some of the heavy and possibly crippling emotions that individuals carry into investing, because in a game the winning of the stake is clearly defined.

If you are a player in the Game, or are thinking of becoming one, there is one irony of which you should be aware.  The object of the game is to make money, hopefully a lot of it.  All the players in the Game are getting rapidly more professional; the amount of sheer information poured out on what is going on has become almost too much to absorb.  The true professionals in the Game - the professional portfolio managers - grow more skilled all the time.  They are human and they make mistakes, but if you have your money managed by a truly alert mutual fund or even by one of the better banks, you will have a better job done for you than probably at any time in the past.

But if you have your money managed for you, then you are not really interested, or at least the Game element - with that propensity to be paid for - does not attract you. I have known a lot of investors who came to the market to make money, and they told themselves that what they wanted was the money: security, a trip around the world, a new sloop, a country estate, an art collection, a Caribbean house for cold winters.  And they succeeded.  So they sat on the dock of the Caribbean house, chatting with their art dealers and gazing fondly at the new sloop, and after a while it was a bit flat.  Something was missing.  If you are a successful Game player, it can be a fascinating, consuming, totally absorbing experience, in fact it has to be.  If it is not totally absorbing, you are not likely to be among the most successful, because you are competing with those who do find it so absorbing.

But the real object of the Game is not money, it is the playing of the Game itself.  For the true players, you could take all the trophies away and substitute plastic beads or whale's teeth, so long as there is a way to keep score, they will play. **

Bradbury K. Thurlow, in his classic 1981 work, Rediscovering the Wheel: Contrary Thinking & Investment Strategy, also discussed the "game" nature of investing.  He wrote about the types of people speculating on Wall Street as follows:

The most obvious division will be between amateurs and professionals.  The former will divide broadly between those who invest / speculate seriously and those who do so primarily because they enjoy the game.  Like all qualitative divisions, this will be difficult to do with accuracy.  The game of speculation, like other competitive sports, gets into one's blood, and one can be wholly and passionately involved in it even as a full-time professional.  Moreover one can play the game with varying degrees of skill.***

Millions of people all over the world own securities, both equities and debt instruments.  Many do this passively by putting their money into mutual funds to be actively invested by professionals.  Someone who is only interested in making money may choose to have the investing done for them.  The individual who is willing to spend the time and effort to pick his or her own investments, in addition to wanting to make money, is also drawn to the lure of the Game being played on stock exchanges around the world.  From what we have seen, for such an individual it is about more than just the money.  The question you must ask yourself is which sort of investor you are.

We will begin our look at the Random Walk theory (the technical name is Efficient Market Hypothesis) in the next blog.

* Excerpt from Reminiscences of a Stock Operator, Edwin Lefevre, © 1923, republished by John Wiley & Sons, Inc. in the Wiley Investment Classics series

** Excerpts from The Money Game by Adam Smith, copyright © 1967, 1968 by Adam Smith are used by permission of Random House, Inc.

*** Excerpt from Rediscovering the Wheel: Contrary Thinking & Investment Strategy, Bradbury K. Thurlow, ©1981, published by Fraser Publishing Company, is used by permission of the current copyright holder.

Comments are always welcome.


Monday, April 9, 2012

Jesse Lauriston Livermore - Legendary Market Trader (3)


The author of Reminiscences of a Stock Operator discussed his experiences as an early trader and then later on, when he had determined how to really profit from his decisions.  He described it as follows:

I made up my mind to be wise and play carefully, conservatively.  Everybody knew that the way to do that was to take profits and buy back your stocks on reactions.  And that is precisely what I did, or rather what I tried to do; for I often took profits and waited for a reaction that never came.  And I saw my stock go kiting up ten points more and I am sitting there with my four-point profit safe in my conservative pocket.  They say you never grow poor taking profits.  No, you don't.  But neither do you grow rich taking a four-point profit in a bull market.  I think I took a long step forward in my trading education when I realized at last that when old Mr. Partridge kept on telling the other customers, "Well, you know this is a bull market." he really meant to tell them that the big money was not in the individual fluctuations but in the main movements--that is, not in reading the tape but in sizing up the entire market and its trend.

And right here let me say one thing:  After spending many years in Wall Street and after making and losing millions of dollars I want to tell you this:  It never was my thinking that made the big money for me.  It always was my sitting.  Got that?  My sitting tight!  It is no trick at all to be right on the market.  Men who can both be right and sit tight are uncommon.  I found it one of the hardest things to learn.

That is about all I learned--to study general conditions, to take a position and stick to it.  In a bull market your game is to buy and hold until you believe that the bull market is near its end.  To do this you must study general conditions and not tips or special factors affecting individual stocks.  Then get out of all your stocks; get out for keeps!

When I am long of stocks it is because my reading of conditions has made me bullish.  But you find many people, reputed to be intelligent, who are bullish because they have stocks.  I do not allow my possessions--or my prepossessions either--to do any thinking for me.  That is why I repeat that I never argue with the tape.  To be angry at the market because it unexpectedly or even illogically goes against you is like getting mad at your lungs because you have pneumonia.

Mr. Livermore believed that tape reading was not as complicated as it seemed to many traders.  He used the tape to determine if the tendency of prices, the trend, indicated that it was time to buy (go long) or sell (go short).  He wanted to know the direction of the market.  He described it as follows:

Prices, we know, will move either up or down according to the resistance they encounter.  For purposes of easy explanation we will say that prices, like everything else, move along the line of least resistance.  They will do whatever comes easiest, therefore they will go up if there is less resistance to an advance than to a decline; and vice versa.

In addition, Livermore advised traders to be patient and wait until the market direction was very clear and then to join in the movement, being careful not to get caught at the top of a market ready to crash.  Getting into the market too early before the trend has become obvious and staying in the market after the trend has started to reverse are the classic ways to lose your money.

He put it best when he wrote, "One of the most helpful things that anybody can learn is to give up trying to catch the last eighth--or the first.  These two are the most expensive eighths in the world."   He references eighths (12.5 cents) because in 1923 stock prices were posted in fractions, not in decimals like today.  His message was, essentially, don't anticipate a market's trend and jump in too early and don't overstay the trend's movement.  Give up trying to capture the first or the last little bit of profit, going in or coming out of your trading position.  Jesse Livermore also recommended an individual trade on his or her own, avoiding advice and tips as much as possible.  It is said that one of his favorite books was Charles Mackay's 1841 classic, Extraordinary Popular Delusions and the Madness of Crowds, which we studied in an earlier blog.

Although Livermore claimed authorship of Reminiscences, I believe that the book was actually written by Edwin Lefevre in collaboration with him.  To me, there is a vast difference in writing styles between Reminiscences and the book, How To Trade In Stocks, written by Jesse Livermore in 1940, the year of his death.   A recent paperback edition of How To Trade In Stocks, with updates and commentary by Richard Smitten, was published by McGraw-Hill in 2006.  The book includes a collection of Livermore's trading records and shows how he calculated his trades.  I must confess I did not completely understand it.

This concludes our look at one of the most famous Wall Street traders of all time.

Excerpts from Reminiscences of a Stock Operator, Edwin Lefevre, 1923, republished by John Wiley & Sons, Inc. in the Wiley Investment Classics series

Comments are always welcome.

Monday, April 2, 2012

Jesse Lauriston Livermore - Legendary Market Trader (2)


In the last blog we learned about Jesse Livermore's beliefs about markets, as recounted in Edwin Lefevre's 1923 book, Reminiscences of a Stock OperatorHe also discussed traders and their make up.  In the book, Lefevre discusses the psychology of traders.  These days the buzz words used to describe the two bases for market action are fear when markets are plunging and greed when a bubble is developing.  Lefevre, writing for Livermore, had a different take on these emotions.  He wrote the following:

The speculator's chief enemies are always boring from within.  It is inseparable from human nature to hope and to fear.  In speculation when the market goes against you, you hope that every day will be the last day --and you lose more than you should had you not listened to hope --to the same ally that is so potent a success-bringer to empire builders and pioneers, big and little.  And when the market goes your way, you become fearful that the next day will take away your profit, and you get out --too soon.  Fear keeps you from making as much money as you ought to.  The successful trader has to fight these two deep-seated instincts.  He has to reverse what you might call his natural impulses.  Instead of hoping he must fear; instead of fearing he must hope.  He must fear that his loss will develop into a much bigger loss and hope that his profit may become a big profit.  It is absolutely wrong to gamble in stocks the way the average man does.

Another danger a trader needs to overcome is the herd instinct, i.e., being swayed by othersGustave LeBon wrote about crowds and the contagion of an idea which triggers market movements.  The author of Reminiscences (Lefevre or Livermore) wrote about succumbing to this pressure several times in his trading career.  He also recounted instances in which he followed the advice of others, again, to his financial detriment.  He wrote, "It cost me millions to learn that another dangerous enemy of the trader is his susceptibility to the urgings of a magnetic personality when plausibly expressed by a brilliant mind."

The traits of a successful trader, in the author's opinion, were as follows:

Observation, experience, memory and mathematics--these are what the successful trader must depend on.  He must not only observe accurately, but remember at all times what he has observed.  He cannot bet on the unreasonable or on the unexpected, however strong his personal convictions may be about man's unreasonableness or however certain he may feel that the unexpected happens very frequently.  He must bet always on probabilities--that is, try to anticipate them.  Years of practice at the game, of constant study, of always remembering, enable the trader to act on the instant when the unexpected happens as well as when the expected comes to pass.

We will look at the trading techniques employed by Jesse Livermore in the next blog.

Excerpts from Reminiscences of a Stock Operator, Edwin Lefevre, 1923, republished by John Wiley & Sons, Inc. in the Wiley Investment Classics series

Comments are always welcome.