I’ve been debating my dad and brother about stock market prediction and the question arose: Does the existence of Warren Buffett prove the efficient markets hypothesis wrong?
To review, my theory — actually the standard theory — is that you can’t really beat the stock market. It’s called the Efficient Markets Hypothesis (EMH). A stock price is a prediction of the future value of a company and unless you have inside information, the market’s prediction is already better than yours. It does seem ridiculous to keep believing in efficient markets after seeing them do blatantly irrational things but the irrationality tends to only be clear in hindsight. Like the dot-com bubble in 1999, for example. It seems like it should’ve been obvious. But in 1999 it was vaguely plausible that, with the internet changing the whole economy blah blah blah, those valuations were legit. If you try to actually predict bubbles, on average you get burned. Seven years after the dot-com bubble it seemed pretty obvious that there was another tech bubble happening. But those prices turned out to be perfectly unbubbly. And, as Keynes pointed out in the 1930s, even when you’re right about a bubble, the market can stay irrational longer than you can stay solvent. This is also related to the concept of a Keynesian beauty contest. I’m not sure if that’s a further monkey wrench for efficient markets or further proves the point about how impossible to predict the stock market is.
Anyway, but Warren Buffett seems to make insane amounts of money by disagreeing with the market. I suppose the hardcore version of EMH says, no, he was initially lucky and then his luck turned into a self-fulfilling prophecy or something. Like it’s easy to make good investments if there are hordes of people mimicking you and driving up the price of whatever you just bought. Which sure sounds like the market being irrational but, I don’t know, we’re back to Keynes’s point maybe?
I’m not sure how reasonable that pooh-poohing of Buffett is and I’m not sure how strong a version of EMH I actually believe in, but I believe in it to some extent. Markets are anti-inductive. If everyone knows that a company’s stock price gradually recovers after taking a hit from bad press, then that’s free money and the money will get scooped up until the thing “everyone knows” becomes wrong. Think of it this way: if low vs high prices are predictable then everyone will buy when they’re low and sell when they’re high and all that buying will drive prices up and the selling will drive them down. That happens until low vs high becomes same vs same. Or random vs random.
My dad was still looking at me all skeptical at this point. Like what about how predictable it is that the company’s stock price tanks on negative press in the first place? Yes but if you’ve read the news story then the stock price has absorbed that news and predicted the effect of it milliseconds upon milliseconds ago. It’s too late for you to profit from it.
Which is all to say that I think if it’s my brother vs the market, the smart money is on the market. It’s like how managed mutual funds are always, in expectation, worse than index funds. I think there are lots of studies on this and it’s pretty accepted wisdom at this point. Basically, it never pays to pay someone to make investment decisions for you. The numbers you might be quoted that would make it seem otherwise are meaningless due to survivorship bias: start thousands of hedge funds, then make all the unlucky ones silently disappear. The survivors can now quote impossibly good historical returns. “Past performance is no guarantee of future results” isn’t strong enough. Past performance isn’t even an indicator of future results when that kind of filtering has gone on.
In other words, even smart investors (except Buffett? but maybe that’s survivorship bias too?) don’t beat the market. My brother’s predictions have actually sounded totally reasonable to me, and yet EMH makes me want to bet against them.
Here was my brother’s previous prediction, from 2018-03-27 17:41 PST:
I hate to say it because I love the company, but I think it’s time to short TSLA.
Tesla is worth twice as much as Ford [according to the stock market], yet Ford (F) made 6 million cars last year at a $7.6 billion profit while Tesla made 100,000 cars at a $2 billion loss. Further, Ford has $12 billion in cash held for “a rainy day” while Tesla will likely run out of money in the next 3 months.
I predict a steady devaluation over the next 120 days as word of their liquid cash crunch goes mainstream. Let’s see if I’m right…
My comment at the time:
I love testable predictions!
(To be clear, even if Steven ends up wrong on this one he still beats all the rest of us who didn’t have a prediction at all. Well, I guess my prediction, if it’s not cheating to make one a month late, is that Tesla’s stock price will stay the same. That would’ve been my prediction a month ago because that’s always my prediction about all stocks because the stock market is smarter than me. EMH, baby.)
Anyway, looks like Tesla has recovered so far. ~90 days to go!
And then at the end of the 120 days Tesla had recovered slightly more. Then it rollercoastered all over the place and is currently way up.
My brother’s current prediction (I wrote it down because I love predictions and am so serious that making specific wrong predictions is way more impressive than making vague predictions where no matter what happens you can act like you were “basically right”):
2019-12-23 07:28 PST: Boeing will beat the market average (the S&P 500, let’s say?) for the coming year.
UPDATE 2020-12-23: S&P 500 up 14% from a year ago, Boeing down 34%.
By EMH, I think it’s a coin flip whether my brother will be right or not but I’m game to have a wager for the fun of it.