Random Walk and Outperforming Fund Managers

I’ve been debating several gentlemen on the 9/11 option grantee issue. The mainstream media (WSJ excepted) has been surprisingly silent on this, so I am gratified that Prof Bainbridge, Larry Ribstein and Eddy Elfenbein have indulged me in a debate on the subject. I went so far as to challenge these gentlement to invest with the corporate management that issues these options.

One of the interesting tangents that came up (via Prof Bainbridge) was the issue of technical analysis and the efficient market thesis. The good prof believes in the latter but not the former.

A few words on the subject are in order:

First, I am not a pure technician. I do use charts, but in combination with sentiment, valuation,  monetary analysis, trend, quantitative data and macro-economics. I am much less interested in the classic pattern recognition TA than I am in Trend and Market Internals. You don’t build a house with just a hammer, and there’s no reason not to use tools that have proven historically useful.   

Many of the charts I use are not what is commonly thought of as pure "Technical Analysis;"  Rather, they are often market internals: Up/down volume, Advance/Decline line, 52 week high/lows, % of stocks below 200 day moving average, etc.  — a true technician would call these quantitative and not technical.

However, I cannot imagine ever buying a stock without first pulling up a chart.  So I guess that makes me reliant on technical analysis in some way.

Second, we should note for the record that the Efficient Market Hypothesis has become an outdated — and disproven — cliche. The Random Walk theory and EMH posits that consistent and regular outperformance of the market is impossible. Even the father of the EMH, Burton Malkiel, the Princeton professor who wrote A Random Walk Down Wall Street, has admitted that the many talented managers have consistently outperformed the indices — something not possible under a truly random walk thesis.

These outperformers include many technical and quantitative driven strategies. Hence, why Malkiel abandoned his so called strong random walk thesis — it was simply wrong. The original concept had too many flaws, and too numerous holes poked in it. So he introduced the weak version, who’s primary attribute is that it is less wrong than the strong verison. Give Malkiel credit for recognizing the theories flaw and attempting to compensate for it.

Why are Markets inefficienct? The aggregation of irrational primates — Human investors. This is a burgeoning field called Behavioral Economics, and has produced several recent Nobel prize winners in Economics. It is also one of the reasons why the efficient market hypothesis frequently fails. See this for WSJ article for more details (if no WSJ, go here).

A perfect example of the failure of EMH can be seen in comments like this one"all information concerning historical prices is fully reflected in the current price."

That’s old school, and it is quite frequently a money-losing falsehood. Pray tell, what was embodied in the price of the market in March 2000, when the Nasdaq was at 5100, profitless stocks were trading at 50 times sales — and the marginally profitable ones were trading at 100 times earnings? Hmmm?

It turns out the market and the information embedded in the stock prices was simply wrong. Stocks were priced too high, markets were at unsustainable levels, and they subsequently crashed. The Nasdaq plummeted 78% over the next 2 1/2 years.

So much for the information contained in that pricing.

Fast forward to October 2002: the Nasdaq was at 1100, and many profitable, debt free companies were trading for below cash on hand. The market, in its pricing wisdom, had determined that a dollar was worth only 75 cents, and that profitable business operations were worth essentially nothing.

So much for the Wisdom of Crowds.

As I’ve written in the past, we have kinda sorta mostly eventually efficient markets — but that is not the same as actually being efficient as described in the random walk theory.

Markets have been shown to exhibit certain attributes – one of which is "persistency" — which makes outperformance possible. Look to these hedge funds with 10 year or better track records for more evidence of trend spotting and trading — what the EMH claims to be impossible.

Theoretically, these people — who have put together terrific long term performance records — cannot exist:

Bernard Baruch?
Bill Dunn (Dunn Capital)
John W. Henry
Tweedy Browne
Warren Buffett
Ed Seykota
Chris Davis
Richard Donchian
Richard Dennis
David Dreman
Louis Bacon
Tom Baldwin
Tom Basso (Trendstat Capital Management)
Peter Borish (Twinfields Capital Management)
Leon Cooperman (Omega Advisors)
Richard Driehaus (Driehaus Capital Management)
Stanley Druckenmiller
Jeremy Grantham
Kenneth C. Griffin (Citadel Investment Group)
Mason Hawkins and Staley Cates
Blair Hull (the Hull Group)
Paul Tudor Jones
Mark Kingdon (Kingdon Capital Management)
Seth Klarman
Bruce Kovner (Caxton Corporation)
Bill Lipschutz
Peter Lynch
Michael Marcus
Bill Miller
William O’Neil
Randy McKay
Roy Neuberger
Mark Ritchie (Citadel Investment Group)
Marty Schwartz
Jim Simons (Renaissance Technologies)
James B. Rogers, Jr (Quantum Fund)
George Soros (SorosTrading)
Victor Sperandeo
David Swensen
Michael Steinhardt
Julian H. Robertson Jr., (Tiger Management)
Monroe Trout
Jesse Livermore
Stan Weinstein
Marty Whitman

And yet they do.

If technicals are voodoo, and quantitative data irrelelvant, than kudos to Bloomberg for building a multi-billion dollar data analysis business on a scam.

Investors who rely on old, cliched and discredited theories do so at their own peril . . .


UPDATE:  July 22, 2006 11:16pm

Incidentally, how efficient is the market if we are just now learning about  the 9/11 option grants, as well as the more than 2,000 companies that appear to have used backdated stock options in the  1990s?

Your answers should range from "Not very" to "Kinda/sorta" to "Eventually"

If the market ain’t all that efficient, then we should expect to see outperforming managers in numbers beyond mere chance . . .

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  1. SINGER commented on Jul 19

    well said…

    the essence is why just say the market is “one way”

    its a kinda sorta efficient market
    technical analysis and market timing are like for the lack of a better analogy recognizing a higher power in the universe(God or whatever you call it)

    If you haven’t experienced a real time instance wherein it helped you predict the markets in contrast to the herd who inefficient misperceived reality, then you won’t believe in it….

    If your trying to win, why limit yourself in the weapons you utilize to do so….

    Props to the Picture


  2. Trend commented on Jul 19

    I find it interesting that so many of these people are Trend followers ….. and don’t follow any fundamentals whatsoever ……. what does that tell us about fundamental analysis and the many CFA’s walking around

  3. GC commented on Jul 19

    Out of these outperformers , what percentage are they of the universe of fund managers ?? …… less than 1% ….. I would posit that would prove why money managers are overpaid and of no value …. and it’s why more and more $ is chasing index funds and ETF’s ….. should be another topic that you discuss at some point

  4. John Navin commented on Jul 19

    I think it’s better to allow them to continue being deluded, Barry. The fewer people who use technical analysis, the better. Let ’em continue to think it’s worthless. We’re better off.

  5. Investorial commented on Jul 19

    Good article, I may have to reference to it the next time I mention market inefficiency.

    The theory itself is liken to looking back 20, 30 years for some data and from the data, finding a favourable conclusion that you were looking for. Statistics is simply that, and it’s up to the statistican to spin the number in a favourable way, and the efficient market theory is an example

    There are good managers, and bad managers. The real issue with the “perceived efficiency” is that bad managers number more. What’s contributing to that?

    The well oiled financial marketing machine for one. How many mutual fund companies and funds are out there? Is it necessary?

    Also, I hazard a guess that most of the fund managers mentioned (if they really exist =) would have in common that they have more control over the way they invest than an unproven fund manager working a 9 to 5 with a company. That fund manager has to answer to the sentiments of its unitholders and may be forced to tweak a portfolio that otherwise would have been better being left alone, becaus their jobs are on the line.

    As for the comments about the managers following trends, I’m not so sure since I’m not familiar with most of the names menionted. I do see a few names not mentioned (David Dreman comes to mind, if I’m correct) that are proponents of value investing, fundamental analysis. Value investing is all about common sense, and working with that in an non-emotional temperment. However the “wisdom of crowds” work with neither of those. So for a value fund manager, unless you get to do what you want to do, it’s not easy to cater to unitholders when the values of both parties are fundamentally different.

    I wonder about the comment regarding CFAs. It it even a prestige anymore?

  6. Investorial commented on Jul 19

    Correction, I meant “perceived efficiency” instead of “perceived inefficiency”

  7. Benny commented on Jul 19

    Trend followers have outperformed for years yet never receive the respect they deserve

  8. PC commented on Jul 19

    I trade the German Bund futures for a living. I am based in Asia and I know “nothing” about the German and Euro economic conditions. I don’t even follow ECB monetary policies.

    However, what I do know is the price action of the bund – all the intra day high and lows (I know them by heart to read the tape) and I know the daily chart price action.

    That’s all I need to know to trade – no fundamentals whatsoever.

    It’s the simplest and most effective way to trade.

  9. Robert Cote commented on Jul 19

    How does Prof Bainbridge intend to demonstrate that Technical Analysis is useless without USING Technical Analysis to support his claim?

  10. GRL commented on Jul 19

    Now that the efficient market hypothesis (and capitalization-weighted index funds based on it) is discredited as bogus, the latest and greatest fashion in the indexing world is “fundamental indexing” as described here:


    And as sold to the public here:


    Barry has discussed this in the past, but not today. How does fundamental indexing alter the anaysis, if at all?

    (Also, I am still waiting to hear what Barry wanted to say on Kudlow about housing last night.)

  11. royce commented on Jul 19

    “Investors who rely on old, cliched and discredited theories do so at their own peril . . .”

    Yet mutual fund investors who choose a index fund in a given category over still have a higher probability of returns superior than those received by investors choosing actively managed funds once you move into multi-year periods. Vanguard’s small cap fund, for example, has done better than 90% of managed funds in its category over the past 5 years, even though its manager does not use technical analysis and all the various tools you’ve mentioned. Not all index funds see quite that level of outperformance, but hardly a case in which investors got screwed from relying on “old, cliched, and discredited theories.”

    I know this is a market blog and you’re a money manager with an axe to grind, but you fail to deal with this issue in your analysis of Malkiel’s work.

  12. Detroit Dan commented on Jul 19

    “If technicals are voodoo, and quantitative data irrelevant…”

    Straw man alert.

    I’m with Joseph Ellis (author of Ahead of the Curve) — to have a good predictive technique, you need a plausible hypothesis supported by data. A purely quantitative approach, e.g. predicting the stock market on the basis of who wins the Super Bowl, isn’t going to work in the long run…

  13. Hans Van Deun commented on Jul 19

    In the end, everybody does what they do best. I’m (going to be) more of a fundamental investor. TA doesn’t really appeal to me personally. And if widespread disgust with incompetent fund managers leads to massive index funds all automatically buying high and selling low, there will be lots of values out there for me to exploit. If technicians and momentum investors ride the downtrend of a stock until you can pick up a quality company for next to nothing, i’m not going to stop them :)

  14. BenG commented on Jul 19

    I’m sure Warren Buffett , Marty Whitman , Tweedy Browne , Chris Davis , Roy Neuberger , Leucadia use technical analysis !!!!!!!!!!!

  15. Eye Doc commented on Jul 19

    It’s not that the trend followers believe that fundamentals aren’t important. It’s that they believe the fundamentals are already reflected in the price. Which means that they’re actually somewhat guilty of believing in efficient markets, doesn’t it?

    It makes me wonder how much of their success is due to position sizing, money management, going long and short, and trading many different markets, and how much is actually due to trend following per se. I’m not disparaging them, because I understand how good they are. I’m just wondering about that.

  16. trader75 commented on Jul 19

    Perhaps Larry Summers said it best (after the 87 crash): “The efficient market hypothesis is the most remarkable error in the history of economic theory.”

    Technical and fundamental approaches can both work wonders in the right hands. And of course they can work spectacularly well in concert. Surprisingly, many virtuosos of one school don’t recognize the value of the other. (Soros is on record as saying technicals don’t work. We know how the trend followers feel about fundamentals.) When it comes to investing approaches, there is an odd provincialism that borders on the religious. Maybe it’s the tribal tendencies in our genes.

    In my opinion the failings of random walk theory are symptomatic of neoclassical economics’ biggest problem in general: a tendency towards gross oversimplification. Economics started out as conjecture and soft theory–guys arguing with each other subjectively and off the cuff, the way poets and philosophers do. The neoclassical approach rescued economics from this fuzzy-headed swamp by applying rigor and logic, but they got so excited about the trappings of hard science that they threw the baby out with the bathwater. “Man, humans are messy. Wouldn’t it be cool if we could invent a robot called ‘rational economic man’ and study him instead? Wouldn’t the formulas be so much more logical and rigorous that way?” And so they took that ball and ran waaaaay too far, creating an artificial world that resembled reality in some ways but grossly distorted it in others. As if in their zeal for exactitude, the neoclassical economists decided that Pi could just be rounded off to 3, and all irrational numbers could be ignored. There are plenty of other areas besides random walk where gross oversimplification dramatically underserves–trade deficit calculations for example–but random walk is the most famous example because it got turned into a rallying cry for mediocrity (hooray, we’re all average!) and a ubiquitous index-fund marketing tool.

    The other reason random walk still survives (in my opinion) is because economics as a field is so polluted by corporate and political influences, and the random walk idea generally serves those influences. The reason that the vast majority of managers can’t beat the market is because real investing / trading skill is rare and thus carries a high premium, but that truth is horribly non-egalitarian and doesn’t play well in Peoria. Better to say no one is skilled than admit that rewards can and will accrue to a small minority on a consistent basis.

    Not to mention that the vast majority of economic forecasters and prognosticators have personal biases akin to cancer researchers getting funded by big tobacco. On top of that, wishful thinking runs rampant in economics and politics–and the myth of a level playing field appeals to politicians, idealists and Wall Street marketers alike.

  17. royce commented on Jul 19

    “The other reason random walk still survives (in my opinion) is because economics as a field is so polluted by corporate and political influences, and the random walk idea generally serves those influences. ”

    It’s the opposite. How does Wall Street sell the services of its managers by pushing random walk theories? Where is the money flowing into DC from the proponents of Random walk, who mostly are in academia? Most people have no idea what the theory entails, let alone follow it.

    As for wishful thinking, I’d rather get a buck for every guy who thought he could outtrade the market than a buck for every guy who thought he couldn’t.

  18. X commented on Jul 19

    Given a wide number of market participants, outperforming the market over the long term is proof of nothing and is easily captured in a random scenario.
    Consider the exercise I remember from finance class: Every student (50 or so) in the room is given a coin at “year one” we flip. Heads, you beat the market, tails, you don’t and sit down (normally half the room). Next round, “year two” same thing, another half the room sits down. Fast forward to “year 10” and a few “market geniuses” have beat the market for 10 straight years…oh my god, how did they do it…

  19. Bob_in_MA commented on Jul 19

    “Theoretically, these people — who have put together terrific long term performance records — cannot exist:”

    Actually, that’s not true at all. Randomness would always allow some chimps with darts to out-perform the market, even in the long term.

    And for how many of those is it really verifiable that they have beaten the market long-term?

    You are always showing this chart and that chart, but you never go back and measure the results if an investor followed these charts after you published them. Like almost all technical analysis, it seems only sure to work in hindsight.

  20. ML commented on Jul 19

    You can debate until the cows come home whether efficient market theory holds or not. One thing you cannot debate is the performance of index funds. They routinely outperform actively managed funds. Before all you stock pickers fly off the handle, fund managers can revel in the fact that BEFORE fees (mgt, transaction costs, taxes) the average fund manager does outperform their relative benchmark. So, what is the lesson learned? Fund managers prove the market efficiency theory wrong every day (can you say Seth Klarman?). However, they are not good enough to consistently outperform their benchmarks and the fact that efficient market theory is about 80% correct.

    For you non believers check out Dimensional Fund Advisors (DFA). They do not pick stocks. How do they consistently outperform their benchmarks? They believe in efficient market theory and they operate as a block trading partner for counterparties that want to dump “bad” stocks. Because of this clearing function that they provide and the credibility that they have earned, DFA almost always acquires stocks a 50-150 basis points below the current market value. They don’t spend a dime on research and they trade so efficiently that they basically eliminate transaction costs. They run a cheap operation and bet on high book/market ratios and the efficient market theory.

    The take away is that you can find plenty of “smart” managers out there. I say “smart” because equating skill to outperformance is difficult. More often than not the outperformance is luck. Nevertheless, most of these “smart” managers cannot beat the flawed efficient market theory when they gouge you on fees.

    BR: Problem is, index funds have underperformed the broader markets for the past 6 years . . .

  21. TonytheTiger commented on Jul 19

    Again with the Turtles!!!!

    Thank you PC, that’s exactly how I trade and I also trade for a living. I trade options on the Q’s short term.


  22. Sestina commented on Jul 19

    X’s argument above is made repeatedly in the book Fooled by Randomness. You set enough monkeys typing and someone produces the encyclopedia britannica sooner or later. There are an awful lot of monkeys issuing buy and sell orders to the financial markets.

    That isn’t to say that the efficient markets hypothesis is true. It just means the existence of winners with well-defined trading strategies isn’t a counter example. From X’s example above, the student who won probably had a very good song and dance about why he predicted the coin flips correctly.

  23. trader75 commented on Jul 19

    It’s the opposite. How does Wall Street sell the services of its managers by pushing random walk theories? Where is the money flowing into DC from the proponents of Random walk, who mostly are in academia? Most people have no idea what the theory entails, let alone follow it.

    Wall Street is an equal opportunity marketer, and random walk theory would not be nearly as prevalent without Wall Street’s support. Every time an investor is convinced to put their money in an index fund or some other faceless vehicle in which the manager is unknown, random walk thinking plays a role. Ibbotson studies and the like have random walk theory as a spiritual father, whether that is spelled out or not. Think about it: how crazy is the idea that you can just throw your money into some passively managed vehicle (or ‘unknown third party with competing interests’ vehicle) and X years or decades later it will all have worked out swell for you. This idea runs absolutely counter to the notion of active self-interest and the requirement of intelligent decision making to produce a desirable outcome. It also runs counter to the notion of intelligent asset allocation, the raison d’etre of capital markets in the first place.

    Personally I think passive investors are some of the biggest gamblers going–the very idea of passive investing as a viable methodology is a philosophical sham. Of course indexing works during secular bull market periods, which can last a long time, but assessing what conditions make for a secular bull market stil requires active thought (and the foresight to get out at the end; 3-month treasury bills have beaten the S&P for 8 years now, as we head into another period of recession and decline). The random walk idea, and the cocoon of comfort it provides, underpins the entire passive investing philosophy.

    As for Wall Street marketing their active managers, who says they can’t have more than one racket? Wall Street is about making money, not philosophical consistency. Random walk theory plays to the fear tendencies of investors, active management promises play to the greed. Get ’em coming and going, it makes for good business.

    On its face, random walk theory was intellectually suspect from the get go. Why would a mechanism as inherently complex and emotion driven as markets exhibit an almost mystical tendency of wholly rational outcomes? In what other areas of reality is “perfect information” distributed without a hitch? The whole concept is philosophically obtuse, an offbeat utopian fantasy.

    Many who defend random walk like to do so by pointing out the holes in TA–but taking potshots at one theory does not prove another, and making light of spurious hand-picked examples certainly does not prove anything. And of course the irony is that the greater the population of investors who place their faith in ignorance, the better the minority will do so who are able to exploit that ignorance.

    In fact arrogance + ignorance is the real problem here. Believing that “no one can beat the market” is a fantastical claim, requiring a much greater depth and breadth of evidence than the statement “most cannot beat the market,” which is empirically verifiable and not all that significant. Much confusion comes from the conflation of these two statements, sometimes deliberate; when the random walker is caught red-handed conflating the two, their argument often morphs into a whiny idealistic protection of the little guy, that hapless joe who can’t beat the market and doesn’t know it and thus needs to be protected from itself. Rather than be a champion of the people, a pointless exercise, I prefer to give the average individual credit for their own decision-making capability and the personal responsibility that goes with it.

    The distinctly un-PC truth, in my humble opinion, is that those who argue vehemently for the random walk have holes in their cognitive framework big enough to drive a Mack Truck through. Fortunately when it comes to markets the skilled trader / investor doesn’t have to convince the hard-headed random walker of anything; they can just keep goin’ about their bidness.

  24. RB commented on Jul 19

    I’m interested in understanding this better. I believe the random walk proponents believe that even if you beat the markets for many years, you cannot do so consistently. The DFA guys even have a list showing market timers underperforming the S&P500:

  25. Craig commented on Jul 19

    None of this really matters.

    If a sufficient number of investors use technicals and charts, and they do, and they control enough total resources, then it doesn’t matter if their analysis is perfect or even reflects reality. They ARE reality, at least for a time.

    If they are a sufficient number then it is THEIR movement we are tracking.

    Right or wrong, if they are large enough in number, they will move the market and determine within a few pts, support and resisitance. Hence you get TA.

    It doesn’t really matter if the TA is the chicken or the egg as long as it indicates the direction of the elephants.

  26. trader75 commented on Jul 19

    Fund managers prove the market efficiency theory wrong every day (can you say Seth Klarman?). However, they are not good enough to consistently outperform their benchmarks and the fact that efficient market theory is about 80% correct.

    Here’s what I don’t get. Who needs a theory that is 80% correct? Why not just throw the $@#$# thing out and admit it was close but not cigar?

    Imagine if engineers were taught structural load theories that were 80% correct. How well would that work?

    There is nothing wrong with “I don’t know,” or “We don’t have a full answer yet.” Plenty of serious scientists make these statements all the time in other demanding and rigorous fields. Yet here we’re supposed to say “Screw it, EMH is clearly jacked up in significant ways but it gets kinda close so we’ll go with it???” That is an intellectual travesty.

    p.s. I don’t see the controversy in pointing out that index funds routinely outperform actively managed funds on balance. This is not an argument in favor of efficient market theory at all! It is an argument in favor of different assertions: that less activity is better than more when it comes to large sums, perhaps, that decisions of general allocation and exposure are more important than decisions regarding the manager selected, and, most importantly, that alpha is in limited supply and will only be generated by a minority of exceptional performers.

    But once again, the random walkers work backwards here. They say “the Seth Klarman instances are few, so we can ignore them or pretend they are just anomalies.” A truly scientific approach, that seeks to explain the phenomenon in question instead of seeking to conform evidence to a preconceived notion, would NOT ignore the Klarman instances, however few, that blow the theory all to hell. Instead, honest economists would willingly go back to the drawing board, and engage in more research and reduction, instead of clinging to a too-big, too-general, too-goofy, “80% correct” theory. But this isn’t happening because inertia, politics, incentives, and ego all play an entrenching role.

  27. M.Z. Forrest commented on Jul 19

    I’m not sure retail stock funds are the best way to evaluate whether the efficient market hypothesis is true. First, they are heavily regulated. Second, their business models are not predicated on beating the market. It is a fee driven business.

    Probably the biggest factor driving underperformance in the long run is funds are not chiefly chosen for wealth preservation; they are chosen for capital appreciation. This leads many funds to chase rallies. This is substanciated by many funds having great one-year and two-year returns, but poor 10-year returns. No disrespect meant to institutions, but they are not investment firms; they are traders with large bankrolls. I have nothing against traders, but it isn’t investing. I have nothing against condo-flippers either, but that isn’t investing.

  28. royce commented on Jul 19


    Compare the fees you can get for an index fund and that which you get for a mutual fund, and I think it’s pretty obvious why Wall Street isn’t too enthused about index funds. ETFs are becoming a different story for brokerage houses, but only because people will trade them like stocks.

    “how crazy is the idea that you can just throw your money into some passively managed vehicle . . . and X years or decades later it will all have worked out swell for you.”

    Not crazy at all, if you understand the concepts involved, the importance of allocation, and the aspects of behaviorial investing Barry frequently references such as overconfidence and a misapprehension of risks by investors, and look at performance histories. VFINX’s record over the past 30 years is 12% annualized. The percentage of investors, pro and amateur, who’ve had a run that exceeds that is pretty small.

  29. ML commented on Jul 19

    Trader 75,

    Wow. You sure are fired up about EMT. I take it from your well-stylized prose and heady vocabulary that you fancy yourself a pretty sharp guy. That being the case, go back and read my comments about EMT again. They do not defend EMT. Rather, they point out the weakness in the counter argument that active managers, on balance, are no better than a “flawed” theory. Did the Seth Klarman comment not bring that out? The DFA example simply shows that managers can rely on EMT if they can generate performance through operations.

    The bigger point is that most active managers are crooks. A very small subset of managers is worth their compensation.

    You brought up “alpha.” Generating alpha sure smacks of academic theory to me. Personally, I don’t care if some manager generates 200 bp of alpha if the net result is still negative or less than the risk free rate. I don’t see that as “good” performance. I see that as a loss. Generating alpha might indicate skill in an academic sense, but it does pass the simple businessman’s test – Did I make money or lose money?

  30. trader75 commented on Jul 19

    Wow. You sure are fired up about EMT. I take it from your well-stylized prose and heady vocabulary that you fancy yourself a pretty sharp guy.

    Actually no ML, not all that fired up. Just enjoy a good debate. It’s a fun and interesting topic, although not all that important in the big scheme of things, as others have pointed out.

    I fully agree with you that the majority of active managers are, if not necessarily crooks, at least not worth their fees. I used ‘alpha’ in the offhand sense to refer to outperformance vis a vis a broader group of managers; of course you are right that, at the end of the day, absolute performance is what matters. (Which, by the way, doesn’t strike me as an EMT-friendly belief. Hmm.)

    Not sure what to do with the sharp guy comment. I write how I write. Don’t have a dictionary by my side; am I to be punished for turning a phrase? (Insert shrug and puzzled look.)

    Royce, fair point on VFINX and the like. In no way did I intend to dispute the truth of that observation, that some passive vehicles have had excellent past performance. I just happen to agree with Larry Summers, that EMT is a remarkable error with a lot of interesting causes.

    As to the outperformance of certain vehicles and measurements in US markets over the past hundred years, I would argue that is primarily tied to the shining performance of the 20th century US economy, which in turn is better explained by big picture historic / economic / cultural / geopolitical factors than an overgeneralized economic theory such as EMT. And while we can look back and see 30 years periods of “Woohoo!,” let us not forget there are also multi-decade periods of “oh crap!” in which an active strategy (or even a sideline strategy) would have beat the pants off a passive one.

    There are certain things about EMT that make sense and certain conclusions born of EMT that are wholly logical. But on balance, I think the whole exercise is so flawed that we would be better off salvaging what’s good from EMT, scrapping the name, and calling it something else entirely. Or better yet, dispensing with the need for a grand theory of markets in the first place. Physics hasn’t come up with a grand unified theory yet, and particles are nowhere near as messy as human interaction, so why should markets have one? I’m mostly against oversimplification I suppose.


  31. ML commented on Jul 19

    Trader 75,

    Jeremy Siegel of Wharton fame makes the same argument that the last 100 of years of performance can best be attributed to “big picture historic / economic / cultural / geopolitical factors.” In his latest book, he makes some interesting (I use that word bc I find some of his logic hard to follow) arguments that the US business and stock market will continue to grow, albeit at a slower rate than the last 100 years. In short, he believes the growth in BRIC will allow the coming wave of baby boomer retirees to dump assets onto the Chinese and so forth as they look for investment vehicles for their impending wealth.

    Interestingly, he has backed off of his “Stocks for the Long Run” call for investing exclusively in index funds. His new book “The Future for Investors” helped give birth to the Wisdom Tree methodology/thesis. He is arguing for passive strategies but against conventional EMT. Wisdom Tree’s fundamental indexing follows his beliefs in dividend paying companies.

    I am interested in peoples’ thoughts on fundamental indexing in general and Wisdom Tree’s products in particular. The theory is not far off from the previously mentioned DFA approach to investing.

  32. HT commented on Jul 19

    Gents/Ladies–wish i could join this lively debate, but after a 30 minute thoughtful [or so I thought] piece i put together–I was “spammed” blocked by the sites [?new] software.

    Wondering if others are having this problem? It’s cool to call Kudlow a “drug addict” and other in sundry ad hominem posts I’ve see lately, I guess, but thoughtful essays are blocked…

    I sent my piece directly to BR—so “what say ye” sir?

    Hope it’s a software glitch, otherwise, the value of this site/discourse, for me, decreases by an order of magnitude.

  33. Vanguard commented on Jul 19

    I’m curious ….

    how has Barry’s fund performed over the years ??!!??!!??!!??!!??!!??!!???

    maybe that will point to his biases

    BR I am precluded from publishing the performance data (its considered advertising) but if you go to this list, you can see the major calls over the past 5 years and extrapolate.

  34. RW commented on Jul 19

    RB, to understand it better you really need to read someone like Malkiel rather than focus on how random walk theory is characterized here. The basic argument is statistical: it does not posit that the market is actually random but that stock prices can be successfully modeled as if it were. Nor does it posit that statistical outliers (outperformers) can not exist, only that there is no way to guarantee such performance can continue.

    In its weak form it posits that the history of stock price movements contains no useful information that, on average, will enable an investor to consistently outperform a buy-and-hold strategy in managing a portfolio; e.g., a lot of folks thought Granville was the ace, then when he fell it was Precter, than Garzarelli, etc. so how, on average, would anyone know they found real talent in an advisor or had the talent themselves? It’s a matter of statistical uncertainty — on average they can’t and/or won’t — but it’s not a matter of impossibility even if some academicians appear to say so.

    The strong form of the theory is quite beyond the pale of sensibility and even Malkiel mocks it a bit, offering the example of an economics professor who sees a ten dollar bill on the sidewalk and passes it by, saying to his students who are attentively trotting behind, “ignore that bill on the sidewalk because if it was really there someone would have already picked it up.”

    Our host has posted a number of comments from successful traders regarding what makes for success and many posters here are also successful and make knowledgeable comments in turn (sometimes casting aspersions on the comments previously posted – lol). Clearly long-term success is possible so what’s really at issue?

    Some years ago I did a study of the Pacific Stock exchange incorporating both quantitative and qualitative (ethnographic) techniques. Made some good acquaintances at the trading desks in the process and gained some insight into trading success that, boiled down to it’s essentials (and with operational skill as an already given), could be described as (1) superb situational attention and (2) excellent money/risk management. Too much detail for a post but the bund trader who posted above gives some insight into the former quality.

    The problem being that, according to the weak form of random walk, no investor on average can rely on any of that over the long term. I think Harry Browne says it better though (I paraphrase): Really successful investors are like exceptional athletes or exceptional people in any field, they have a talent, and exceptional talent by definition is not common or we wouldn’t recognize it as such. Unless you (the individual investor) have clear evidence you possess comparable talent you had better learn how to diversify, manage costs, and trim the odds against you.

  35. royce commented on Jul 19


    I agree that active management can work better in particular periods. And for the passive approach to work there has to be a huge number of active investors to form the market and price stocks. So active investing isn’t going to fall out of fashion.

    My beef was more with Barry’s implication that the strategy was outright foolish.

  36. HT commented on Jul 19

    well put RW–

    ‘selection bias’ is the operative statistical term and needs to be clearly understood by all who make money manager selection decisions [or choose not to…]. That, and ‘regression to the mean’, are arguably the most important ‘concepts’ for someone trying to manage their own money. And, in my opinion, need to be deeply understood.

  37. JoshK commented on Jul 19


    I think you misunderstand the theory a bit. It suggests that few people will be able to beat the market. Not that no one will. As you widen your horizon, fewer people outperform.

    Most of the basic models that I see people using are based on Markov processes and the like, which, IMHO, means that people still assume quite a bit of unknown randomness.

  38. HT commented on Jul 19

    This has been a valued site in many ways, but the number of folks with what I call “guru-itis” is astounding. There are now over 8,000 hedge funds, not to mention thousands of other actively managed non-hedge vehicles, but 20 names are proof of the ability to confound the market? I have learned a lot from this site–specifically the piece on markets following p/e expansion and contraction not earnings as hugely enlightening. Thanks to BR. But I’m beginning to wonder how one can justify on the one hand telling everyone that forecasting is foolish, yet later tout the genius of those [few] who made millions doing it. After all, there’s a one in a thousand chance of getting 10 heads or 10 tails in a row–if 10,000 people play the game, ya got your 10 guru’s.[retrospectively of course–which is the point]

    No, I’m not Taleb with a pseudo-pen name, but consider reading ‘Fooled by Randomness” folks. Consider understanding in depth the two most important statistical factors at work in trading–selection bias and regression to the mean.

    Yes, I called the real-estate bubble, emerging market bubble, and small cap bubble–but, alas also got out earlier than I should have to have created maximal profitability. Recognizing market imbalances actually isn’t too difficult if you can control primal ‘greed and fear’ instincts, but that doesn’t mean you can nail the top and bottom with any certainty. And when you add in fees, and most importantly taxes—a topic I have yet to see discussed here [namely 15% long term cap gain hit v. what I suspect is 40-50% marginal rate for many high income, high tax state folks here for short trades– is huge], the value add of being active becomes harder. [abolish all profits on capital gains, and we might have a different game…]. Yet we aare here trying.

    Lastly, in case there is a young PhD in economics candidate out there, what about developing and proving a ‘Universal Field Theory of Efficient Markets”? Namely, perhaps that markets ARE truly efficient, but to BR and the other critics–perhaps what you are objecting to is that those theorists are not in fact measuring ALL the component variables. So, if one could accurately measure market fundamentals, technicals, sentiment, neuroeconomic decision making, macroeconomic/social- political volatility, one may actually be able to say the market is, in a sense efficient in that all data is being measured and reflected in a price instantaneously; –very different than saying that an individual may agree/disagree with that calculation. And, as far as I know, this is not capable of being done anyway—but may make a nice doctoral thesis though…

    One last rant, as a [successful] dot.com entrepreneur that sold his company in 2001, one comment that people forget in the current rise to glory of Google et al. Guess what, the ‘eye balls’ metric that the VC’s used to justify valuations in the 90’s—which was first embraced [overly so with typical human greed], and then sneered at after the crash [also typically, due to human fear] was actually [news flash–heard it here first] right! It was, in fact, the correct metric to use—it took time and Google, [e.g. Google’s adSense] among others to figure out a way to monetize the phenomena, and regression to the mean to bring growth prospects of Internet commerce in line with reality. MySpace just sold for $500M because it was able to draw 50M unique visitor in under a year, advertisers have an easy way to measure ROI for their investment, and online marketing works.

    The facts are, the greatest way to amass great wealth quickly is to 1. inherit it [sadly, not my case–but probably screws a fellow up anyway…], or create a great company. Investing is key, but unless one is actually gambling, is a longer, slower process.

    Thoughtful comments/responses encouraged–but please no flames. I tried [and it was my earnest goal] to be respectful to all. Just needed to respond to this trail.


  39. John Nyu commented on Jul 19

    Barry, you either don’t understand Random Walk or are misrepresenting it. The theory states that some people will outperform. They’re called “Expert Coin Tossers.”

  40. BDG123 commented on Jul 19

    Index funds have only underperformed if you’ve been in the wrong index funds. Emerging markets, oil, broker dealer, transports, small caps, energy, metals, etc, have all outperformed as indices.

    Trader75, how many iced venti mochas have you had today? You went on a rant proportional to mine. lol.

    Btw, “Imagine if engineers were taught structural load theories that were 80% correct. How well would that work?”

    They were. It’s called the Big Dig in Boston. lol.

  41. Barry Ritholtz commented on Jul 19

    As to EMH, I understand it fine — I did skip a step when discussing it.

    Yes, a truly random system (market) will produce outperformerers by chance.

    Problem is that there is an excess of outperformers — people who put together investable theses that both correlate with their market/stock calls, and correspond on a causal basis to their theories.

    Any data challenging a given theory can be derided as random coin tosses. I think it is incumbent on the EMHers to look at some of these outperformers to determine if their performance is a basis of luck or something else.

    Merely yelling “LUCKY SHOT” is a school yard taunt; I need to see more than that before I buy into the EMH — weak or strong.

  42. wcw commented on Jul 19

    The way I see it, it’s not so much an excess of outperformers as an excess of consistent outperformers. Dart-throwing monkeys will fall off a cliff at a certain rate; if you run some plausible numbers, you will see that the stars do fall off the cliff, but not at a high enough rate to make any sense at all.

    In re: DFA, if they beat a large-cap index by 150bps without taking on any relative risk, I’d like to see that documented. In small-caps, I absolutely believe their methodology works.

    My advice for generating alpha to those who don’t get paid to do it directly is to index substantially all their money and to get a raise. When you’re 65 this is bad advice, I grant, but I chat with my peer group, and at 30 or even 40 a 10% raise usually beats 100 bps of alpha, and that is indeed without taking any relative risk.

  43. John Kuran commented on Jul 19

    EMH requires 2 things: rational investors and a normal distribution.

    (1) I think Barry pointed it out that Eugene Fama, the father of EMH, recenctly admitted that investors can be irrational at times. I think that there are too much human emotions, wrong decisions, etc. involve in the financial markets for investors to be rational.

    (2) take a look at the price distribution of any market index. There’s no way the normal distribution can best describe it – there are too many fat tails. A Cauchy distribution or a Stable Pareto Levy distribution best describe market action.

    The implications of (2) is that the market does not conform to a random walk theory (just because it is precisely unpredictable doesn’t mean it’s random) and the short term time frame is ‘predictable’ while the long term is not. ‘Predictable’ in the sense of a weather forecast (not a bad analogy as both the markets and weather system are example of a nonlinear dynamical system): you can make a good prediction of the weather of the next 3 days, if you keep it rough enough, but not for 3 years away, 3 months or even 3 weeks out. Rough in the sense of something like this: A high pressure system is moving in, kicking out the rain of the last 2 days, expect highs in the ’80s, etc. Not something like this: at 2:54pm EST, it will be 84F at the corner of Wall St. and Broadway. That is expecting too much.

  44. poison_fish commented on Jul 19


    You of all people should know that data sets always contain anomalies. Out of literally millions upon millions of data points you point to a handful that are near the higher end of the range. In stats, these points prove nothing. You must look at the entire set to prove your point. If you throw 1,000 darts and hit bulls eye 50 times it is not fair to say that you hit bulls eye 50 out of 50 times. These throws prove very little when looked at in the entire data set.

    Money managers are the same. A small handful actually outperform a standard index fund over the very long term. This is even more true for hedge funds. I would die to see how some of those funds do when you back out taxes and fees. 25% for fees and 35% for taxes is why most hedge funds are a horrible investment.

    This is not to say that outperforming the market is impossible. It just goes to show how extraordinarily difficult it is. Most people are better off saving themself the trouble.

  45. whipsaw commented on Jul 19

    The only people who can afford to suggest that you can trade without using TA are FTPFs (Fully Tenured Professors of Finance) because they cannot be fired. They can hypothesize all that they like, but In Real Life you might pick something based on fundamentals, but you would not enter or exit the trade without consulting the chart. Even at that, fundamental analysis is broken because of margin compression, so just go with the chart. How often have you heard some PR bunny say “We are going to have to restate the chart for the last 3 years, but it’s okay?”

    What I would really, really like is for the Wharton professors (even the ones who did not contribute to LTCMs downfall) to provide a daily advisory service. They could call it tell.com and those of us who actually make money in the market could use their alerts to go opposite. I’d pay $300 a year for that, no problem.

  46. ML commented on Jul 19

    It’s funny to hear so many traders trash EMT on hand and arbitrage on the other. Arbitrage only holds under EMT.

    It’s easy to run out the tired old LTCM example, but in doing so, one ignores the billions of dollars those guys made for 4 years. Their failure was a function of not understanding the principles of correlation under market panic. Russia defaulting on bonds did not equal a correlation of 1 in LTCMs models. That mistake sunk them. All they money they made previously was pure EMT at work.

  47. SoCal Chris commented on Jul 20

    If index returns are there for the taking, won’t an efficient market guarantee that the outperformers’ fees will be “bid up” to a level where net returns equal the index?

    Maybe if we looked at net returns, the number of outperformers would be consistent with EMT … and we would be left with the nascent outperfomers who’s fees have yet to reach “parity”.

    In other words, if “free money” can only come from new outperformance, maybe the distribution of returns is that which EMT predicts.

    Or, maybe the fact that outperformers’ fees are often bid up to a level resulting in below average net returns proves an inefficient market.

    Oh, but I left out taxes …

  48. dsquared commented on Jul 20

    Two points.

    First, on Vanguard, specifically:

    Vanguard’s small cap fund, for example, has done better than 90% of managed funds in its category over the past 5 years, even though its manager does not use technical analysis and all the various tools you’ve mentioned

    Yes they do. Vanguard, Barclays Global Investors and State Street are probably the biggest users of quantitative analysis (and certainly the biggest employers of quants for investment management) in the market.

    The reason for this is that Vanguard et al do not, in fact, follow the strategy of buying and holding the entire index. They don’t because this is a monstrously inefficient trading strategy for a firm that has to provide liquidity for inflows and outflows – the average position size is well below the optimum.

    What index trackers do is to construct a portfolio which minimises tracking error. There are many such potential portfolios, and a considerable degree of skill goes into constructing the best one. Also, when constructing your tracking portfolio, you are always looking to give it an “alpha tilt” – a little bit of outperformance to help pay your management fee. Vanguard in particular are gods at achieving this.

    What people need to realise is that there are good and bad trackers (some of the worst-managed tracker funds have performance that is nothing short of embarrassing) and if you are comparing active managers to Vanguard, you are comparing them to the Warren Buffet of trackers.

    Second, on the coin-tossing issue:

    This isn’t a valid statistical argument. It is true that if you hold a coin-tossing tournament, somebody will win. But if you then hold a second coin-tossing tournament and the same guy wins, then have a look at his coin because this would be an extremely unlikely event under the assumption of a fair coin.

    Buffet, Soros et al were identified as great investors at least twenty years ago. At that time, it might have made sense to call them “Lucky tossers”. However, they have continued to maintain their performance records ever since then. The hypothesis of an unbiased coin has hardly any support at all.

  49. royce commented on Jul 20


    I’m aware of how they put indexes together, and it was pretty obvious that I was talking about using TA as a stock picking tool. So why bother addressing an argument that was never made?

  50. JoshK commented on Jul 20

    I dont’ know if this thread is done, it’s a pretty good one and a frequent topic of conversation. If there was only one person who consistently outperformed the market, then most people would agree it could be luck. If there were thousands most people would agree it would be skill. I’ve heard people use the term semi-strong EMT, which may be better. Trying to strickly apply EMT would be tough.

    But, it also begs a lot of philosphical questions in defining alpha itself. If you say you outperformed the market, then what market are you talking about? If you were in US stocks while the market in Finland went up 40% or out of NASDAQ when it went up 30% (or whatever high %’s it was hitting), did you underperform? Time horizon and asset base is very tricky and the framing is difficult.

    I think the economist did a little piece once showing how much money you would have if you just put $1 into the best market each year world wide over the last 100 years. You would buy Jan 1 and sell Dec 31. The result was something huge, I think they said more than all total world assets.

  51. dsquared commented on Jul 20

    I’m aware of how they put indexes together, and it was pretty obvious that I was talking about using TA as a stock picking tool. So why bother addressing an argument that was never made?

    Because you said that Vanguard doesn’t pick stocks or use technical analysis and they do. In fact, they use algorithmic technical analysis; “trading systems”, the very most reviled area of TA in the academic literature.

  52. royce commented on Jul 20

    “Because you said that Vanguard doesn’t pick stocks or use technical analysis and they do.”

    Their goal is to model the index involved, not identify which stocks will outperform other ones or predict the movements of markets using technical analysis. So they use TA in their model. So what? You’re bringing up an irrelevant detail on an issue nobody is discussing.

  53. kharris commented on Jul 21

    Speaking of intellectual error — “These outperformers include many technical and quantitative driven strategies.” The “outperformers” you listed were people, not strategies. It does not necessarily follow that the strategy used by the investor is the ultimate source of the investors success. Trade75 argues that real investing skill is rare (backing the claim with pure twaddle – “it’s because the public won’t tolerate excellence like mine!” – please) is consistent with trading success not being well understood. It is no accident that techies mock fundies and quants mock both. Each group, wrapped in the normal human urges for affiliation and control, claims that it is the trading theory practiced by members of the group that account for their excellence. Iconoclasts (whose affiliation is with other iconoclasts) claim that they use a bit of this and a bit of that, but still claim that they have “knowledge” which they may not, in fact, have. If all this stuff works, some of the time for some people but not all of the time for anybody, then still we don’t know what works.

    Mighty cheeky to crow over Malkiel and Bainbridge committing supposed intellectual lapses and waving around behavioral economics as evidence, in the midst of one’s own intellectual lapse, based on some common forms of irrationality.

  54. Anonymous commented on Jul 22

    Random Walk And Outperforming Fund Managers

    Barry Ritholtz discusses technical analysis and efficient markets.

  55. dsquared commented on Jul 24

    So they use TA in their model. So what? You’re bringing up an irrelevant detail on an issue nobody is discussing

    If the fact that they do is “an irrelevant detail”, then why did you, in your original comment, think it was so important to say that they didn’t?

    The quantitative strategies used at Vanguard and other trackers have two objectives; to minimise tracking error, and to generate alpha. “Generating alpha” is done by picking those stocks which will outperform the others.

  56. Massi commented on Sep 1

    I have just read the post and the comments. While I share some of the views, for example that one should use TA and other tools with economic theory to pick stocks, I find myself in much disagreement on the way the Efficient market hypothesis, especially in its weak form, is treated.
    I have written a Blog that explains the EMH, what it says, and what it does not say, and relate it to the article and comments here.

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