Everything You've Learned About Investing Is Wrong!
Well... how is that for a rather startling statement?... An e-mail from one of our members suggesting that I might have been somewhat mistaken in my comments at last evening's meeting concerning the definition of an asset prompted me to use that title. However, I shall remain unrepentant, as I was (and still am) speaking from the perspective of an investor; and while I may have stated this in a rather simplistic manner (in order to get your attention) when I said that an asset is something that places money in your pocket while a liability is something that takes money out of your pocket!... This may appear to contradict the definition that some academics attribute to the word "asset" however, it does make abundantly good sense when you are thinking as an investor!
There is an interesting new book out in which the author states, "The 20th century was an off-the-charts calamitous era in stock markets... or perhaps our assumptions were wrong... The entire field of investment analysis is founded on a few shaky myths."
The book I speak of is, "The (Mis)Behavior of Markets," and the author's name is Benoit Mandelbrot.
Mandelbrot states that, "Basically, everything you've learned about investments is completely wrong, as it's been built on faulty assumptions." Mandelbrot says that the accepted wisdom substantially underestimates the potential for loss. In plain English, financial markets don't follow a "normal" pattern.
Here are a few examples that Mandelbrot gives:
* If the market followed a "normal" pattern based on statistics over the last century, there should have been 58 days when the Dow moved more than 3.4%. Instead, Mandelbrot found there were 1,001 such days!
* Similarly, the "normal" assumption of Wall Street suggests six days of index swings beyond 4.5%; in fact there were 366 such days!
* Index swings of more than 7% should come once every 300,000 years; in fact the 20th century saw 48 such days!
So Wall Street's basic assumption, that everything should fit as "normal," is wrong!
"Normal" is what the academics want. It's what all the work they've done is based on.
For example, the "normal" assumption by academics is that yesterday's price change does not influence today's... each price change is independent from the last.
Another theory based on "normal" is the efficient market theory... that markets won't boom or bust because markets are efficient... they are correctly priced at basically every moment.
This is all hogwash, says Mandelbrot. The accepted wisdom says that prices move randomly. Mandelbrot says price changes are not random... "Today, in fact, does influence tomorrow"... "If prices take a big leap up or down now, there is a measurably greater likelihood that they will move just as violently the next day... Whatever the explanation, we can confirm the phenomenon exists - and it contradicts the [normal] model."
What we need to know about how markets differ from popular perception:
1. MARKETS ARE RISKY. Much riskier than most imagine.
2. TROUBLE RUNS IN STREAKS. Contrary to the accepted wisdom that stocks move randomly, big moves are often followed by big moves.
3. MARKETS HAVE A PERSONALITY. Markets are driven by the actions of people, not by fundamentals, wars, etc..
4. MARKETS MISLEAD. Investors love to find patterns and statistical mirages where none exist.
... Whether or not you agree with the observations of this 80-year old author, his comments should serve to alert you to the importance of doing a better job of estimating the risk you take whenever you buy a stock or shuffle your portfolio.
And finally, never lose sight of the most important message contained in this book:
You can lose more money than Wall Street previously thought... or wanted to admit!
* * * * *
There is an interesting new book out in which the author states, "The 20th century was an off-the-charts calamitous era in stock markets... or perhaps our assumptions were wrong... The entire field of investment analysis is founded on a few shaky myths."
The book I speak of is, "The (Mis)Behavior of Markets," and the author's name is Benoit Mandelbrot.
Mandelbrot states that, "Basically, everything you've learned about investments is completely wrong, as it's been built on faulty assumptions." Mandelbrot says that the accepted wisdom substantially underestimates the potential for loss. In plain English, financial markets don't follow a "normal" pattern.
Here are a few examples that Mandelbrot gives:
* If the market followed a "normal" pattern based on statistics over the last century, there should have been 58 days when the Dow moved more than 3.4%. Instead, Mandelbrot found there were 1,001 such days!
* Similarly, the "normal" assumption of Wall Street suggests six days of index swings beyond 4.5%; in fact there were 366 such days!
* Index swings of more than 7% should come once every 300,000 years; in fact the 20th century saw 48 such days!
So Wall Street's basic assumption, that everything should fit as "normal," is wrong!
"Normal" is what the academics want. It's what all the work they've done is based on.
For example, the "normal" assumption by academics is that yesterday's price change does not influence today's... each price change is independent from the last.
Another theory based on "normal" is the efficient market theory... that markets won't boom or bust because markets are efficient... they are correctly priced at basically every moment.
This is all hogwash, says Mandelbrot. The accepted wisdom says that prices move randomly. Mandelbrot says price changes are not random... "Today, in fact, does influence tomorrow"... "If prices take a big leap up or down now, there is a measurably greater likelihood that they will move just as violently the next day... Whatever the explanation, we can confirm the phenomenon exists - and it contradicts the [normal] model."
What we need to know about how markets differ from popular perception:
1. MARKETS ARE RISKY. Much riskier than most imagine.
2. TROUBLE RUNS IN STREAKS. Contrary to the accepted wisdom that stocks move randomly, big moves are often followed by big moves.
3. MARKETS HAVE A PERSONALITY. Markets are driven by the actions of people, not by fundamentals, wars, etc..
4. MARKETS MISLEAD. Investors love to find patterns and statistical mirages where none exist.
... Whether or not you agree with the observations of this 80-year old author, his comments should serve to alert you to the importance of doing a better job of estimating the risk you take whenever you buy a stock or shuffle your portfolio.
And finally, never lose sight of the most important message contained in this book:
You can lose more money than Wall Street previously thought... or wanted to admit!
* * * * *
posted by Bob Moser at
4:12 PM
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