Hunting for Alpha – is it a fool’s errand?

Classical economists and academics tell us we are on a fool’s errand. I first learned that earning returns over and above “the market” over the long term was solely a matter of luck in college finance courses. The irony struck me immediately. I sat in a classroom, where the majority of the students were going to go into the corporate investment or banking field. That meant that certainly some of these students would go on to be money managers, not a few of which would aspire to beating the market for their clients. They would learn that they could not beat the market except through taking greater risks, or by luck. Yet their very professional existence would rely on selling the idea to others that they could manage a clients money better than passive index trackers or the individuals themselves.

Something smelled fishy to me on that day. And the more I learned about the efficient market theory, the more convinced I was that the market could be beaten. While the successes of Warren Buffett, Jim Rogers, George Soros, and Peter Lynch could be the result of extremely long bouts of luck, I just didn’t believe it. I had a gut feeling that people were not behaving rationally, and that there was money to be had in exploiting that.

The belief that investors can’t beat the market without taking on additional risk stems from the “efficient market hypothesis” popularized by a University of Chicago professor, Eugene Fama in the 1960’s. Efficient market theory states that, since all information needed to price equities is equally available to all participants, all information will be priced into stocks instantaneously. Any illogical mispricing that develops will be exploited by other rational investors (arbitrage), until the mispricing corrects itself. Not all investors need be perfectly logical; all that is needed is that irrational actions within the market should be random, and rational investors will not be able to predict aberrations in price in the long run.

The hypothesis makes sense to me only if the following hold true:
A. Most, if not all irrational behavior is random and unpredictable
B. Arbitrage is possible. That is, exploiting obvious mispricing is riskless
C. Information is reliable, timely, and available to everyone on equal terms

Obviously, I don’t believe that these three conditions exist. First, I recognized early on that people did not behave in the rational manners that economic models relied on. I recognized overconfidence in investors early on, as I begin investing in the runup to the tech bubble burst in 2000. Warren Buffett had written a description of both market bubbles and market cycles in a case study we were required to read, and I spent months arguing to friends that the market had to crash at some point. I was meant with anger arguments, from poly-sci majors with a passion that exceeded even religious debates. If ordinary people could vehemently oppose my suggestion that 20% growth could not continue indefinitely, than I knew that something truly powerful was pushing markets beyond reason.

As for the second point, I don’t want to delve too deeply in the topic yet. I feel that arbitrage deserves its own post, and I’ll try to get to it as soon as possible. Let me just give a related, if simplistic and perhaps inaccurate example. As discussed above, I was under the impression that a crash was imminent. The problem was, I didn’t know when. I’d read claims from 1997 that stocks were overpriced, and I’d read the scathing critiques against those “perma bears”. At the time, if one wanted to bet against the stock market, one had three choices.

A. Short several stock or the index
B. Purchase calls on stocks or the index
C. Get out of the market

As a young, college student, I wasn’t ready to sell stocks short or purchase puts. Besides, these routes require you to be pretty dead on timing wise. If shorting a stock, one faces interest rates and margin calls. The position is not tenable forever. If purchasing puts, the time limit is more obvious. Turn a profit prior to the exercise date; or else.

I didn’t have money in the market, so I chose to stay out of the market. It paid off, but it isn’t a strategy that generates much money. Besides, had my timing been off for a few more years, it might have proved a costly strategy as well.

The third point is that information must be available to all market participants at the same time, and that it must be timely and reliable. Again, this is a topic best discussed by itself, but let’s examine it briefly, none the less. Do we really believe that no information makes it to some portion of investors prior to its public release? Do we really believe that each piece of information can be properly digested and given proper weight amongst the thousands of other pieces of chaff and noise information spewed by the 24 hour news machine that is cable and the internet? Do we believe that complex industry information can be equally analyzed by all investors in that particular industry, or do we recognize that certain parties will be able to interpret the information far more efficiently than the vast majority of participants?

If we do not believe that the efficient market hypothesis holds, than there may be room to exploit inefficiencies in the market. We can’t guarantee success, but we should be able to reduce risk inherent in a portfolio, while increasing returns. But we will need to understand how people react to specific situations, so that seemingly random irrational behavior may become somewhat more predictable.

Fortunately, behavioral finance, explored by Amos Tversky and Daniel Kahneman in prospect theory, offers a glimpse into the human decision making process and how it applies to decisions made regarding money. If we examine the findings in prospect theory and other behavioral studies, we may be able to find trades that hold higher expected returns (total payoff X probability).

I would be interested to hear any thoughts on this matter, especially defenses of the efficient market hypothesis.

T.R.