Professor Jevons Lee
May 18, 2012
Effective Investing: Barons that Beat the Market
The most pertinent question to modern investors is whether it is possible to predict prices and attain arbitrage. Since the time when academics first entered the field of financial investing after World War II, the developments in the stock market have encircled this central question. There have of course been developments on both sides, as men like Alfred Cowles and Eugene Fama have made their cases for market efficiency and random walk. On the other hand, intelligent minds and practitioners such as Warren Buffet have made their living through the stock market, millions of dollars and significantly exceeding market returns. As a result, the question remains whether it is possible, specifically for the average investor, to invest in such a way as to confidently expect to beat the market. It is determined that, in the short run, prices are unpredictable and therefore, short run arbitrage is nearly impossible for the average investor. However, through fundamental analysis of a company and knowledge of the industry, including competitors and growth opportunities, it is possible to confidently estimate the value of a firm in relation to its current market price. In that way, it is reasonable to obtain returns above the market average. However, without the help of an analyst, or some special expertise, this also is nearly impossible for the average investor. Alfred Cowles and Market Efficiency
In 1933, Alfred Cowles asserted that the boastful attempts of stock market forecasters to predict future stock prices were ineffective and possibly even detrimental to their advisees. Using heaps of data, carefully documented and organized, Cowles showed that over more than four years during which he conducted his research, the results of financial services and insurance companies, rather than handily beating the market as promised, actually provided a lower return than the market [ (Bernstein, 1992) ]. Cowles additionally analyzed the use of the Dow Theory, developed by Charles Dow and popularized by William Hamilton, the long time editor of the Wall Street Journal. This theory is dependent on the analyst’s ability to predict the turn of a market trend, as the turning of an ocean tide. It assumes that the market will follow a pattern of increase or decrease until a specific and identifiable point, at which it changes direction. The results were similar to the finds about financial services and insurance companies. Cowles summarizes the findings as follows: From December 1903 to December 1939, Hamilton, through the application of his forecasts to the stocks composing the Dow Jones industrial averages, would have earned a return, including dividend and interest income, of 12 per cent annum. In the same period the stocks composing the industrial averages showed a return of 15.5 per cent per annum. Hamilton therefore failed by an appreciable margin to gain as much through his forecasting as he would have made by a continuous outright investment in the stocks composing the industrial averages [ (Cowles, 1932) ]. Hamilton was among the most famous stock market analysts of the era, and Cowles showed him to have been thoroughly defeated by the market itself. It appeared clear that there was no systematic method to beat the market and attain the arbitrage that all investors dream of. In July of 1933, Cowles was thought to be ludicrous, and was immediately dismissed by the majority of the investing community, including his neighbor, Robert Rhea, who used various arguments to attempt to prove Cowles’ bias and the ineffectiveness of the data [ (Bernstein, 1992) ]. It must be recognized that Rhea had strong arguments against Cowles’ data. The data was not based on explicit advice given by Hamilton, but rather vague statements that were determined by Cowles and his team to be a recommendation to buy, sell or hold....