Before we explore the logic in the title, let’s start with a simple experiment: a game of coin toss.
Let’s assume you start with a wealth of $100 and perform a sequence of coin tosses. When the coin lands on heads, you get a 3% increment to your wealth, and when it lands on tails, you lose 3% of your wealth.
After repeating this process 1,260 times and plotting the amount of wealth at each interval, this was what I got.
I then compared this to the S&P 500 index over 1,260 trading days.
In a blinded-experiment conducted with some of my students from the Singapore Management University, most of them said that the coin-toss results looked more like a stock market chart than the actual S&P index itself!
The concept that we have just demonstrated is known as the Random Walk Theory.
Mathematicians have observed that stock prices follow an unbiased pattern of probabilities and no single person can always win by identifying and playing the correct strategy. Financial economists have also failed to identify a significant population of fund managers who can consistently deliver higher-than-market net returns over time.
Eugene Fama, the 2013 Nobel Laureate (Economics), attributed this phenomenon to the workings of an efficient market. In an efficient market, stock prices move quickly in response to new information about their companies’ earning potential or level of risks being undertaken. Thus, it’s impossible for any investor to earn above market returns by purchasing undervalued stocks or selling them at inflated rates, except through luck.
Stock markets in developed countries tend to exhibit a form of market efficiency that is known to be semi-strong. This means that stock prices at any point in time would reflect all publicly available information relating to the company and the macro-environment affecting it.
Even when a highly skilled investor such as Bill Miller – who led the hugely successful Legg Mason Value Trust – was asked about his miraculous record, he attributed 95% of it to luck. True to this, Legg Mason Value Trust’s performance started to decline from 2006 onwards, became one of the worst performing funds in its category in 2007, and finally hit an all-time low of -55% in 2008 (while the S&P fell only 37%).
Efficient markets do not necessarily mean that investors cannot make money. They can – and do – still earn higher returns when they strategically invest in high-growth companies that are among the best in their respective industries. In addition, investors can also reduce their risk exposure when they invest in well-diversified global portfolios.
My point is, just as we wouldn’t think that we can win lotteries through skill, we should not harbour the illusion that skills play the all-important role in picking stocks. It is, in fact, quite heavily dependent on luck.
Dr. Jack Hong is the co-founder of Research Room Pte. Ltd., a management consulting and advanced analytics company that delivers complex prediction and decision-making capabilities for commercial, government, and not-for-profit organisations. Dr. Hong has extensive research and commercial experience in applying advanced empirical science to drive business, financial and policy value chains. He is concurrently an adjunct faculty with the Singapore Management University (SMU).