Monday, May 25, 2015

Malkiel's "A Random Walk Down Wall Street": Thank God for Active Traders

I have no beef against the active traders. Maybe I have a little pity for them, since half of them have to lose money if the market’s a zero-sum game. That’s more than half, once you start to factor in fees.

I have long ago realized that though I am interested in the workings of the market, I am not going to delve to the minutiae of companies and different trades and try to be smarter than someone else on the other side who thinks he’s doing the same thing. Nope. Malkiel and Bogle figured out a way I could get away with making the most return possible with the least effort possible - indexing.

Basically this book is a defense of the efficient market hypotheses, or at least part of it. As I understand it, there are two parts to the EMF. One is that the price is always right. So that there’s no such thing as a bubble ever because all the valuations of the market price of securities are representative of their underlying value. The other part is that there’s no free lunch. Or basically arbitrage opportunities may exist, but they are not predictable nor do they persist. I think that the second part is more true than the first, and that’s what this book really digs into, showing you that there are no persistent ways to beat the market. If that’s true, then the best way to consistently make money is to just buy the market. Thankfully there are financial instruments that make that possible - and they’re where I have my money. Cards on the table, this book is just a giant exercise in confirmation bias for me, but it is confirmation bias well done in clear writing with a well-organized structure. I read this burning through the pages on a long holiday weekend, and I wanted to send it to my parents. I thought again about that. It might be too late for them since I don’t know their financial positions. Maybe I’ll send it to my siblings.

A final note, though. Even though Malkiel shows convincingly that there is no way to beat the the market, there is an odd paradox. For the market to work, it needs people out there who think that they can beat the market. Even if the best strategy is to buy and hold a low cost index fund, if everyone did that liquidity and price discovery would drop. What someone following Malkiel needs is people who think he is wrong and that they can generate “alpha” (returns above the market). This goes against the second part of the EMF, where arbitrage opportunities can’t exist because if you have a way to beat the market, then everyone has a way to beat the market and then once everyone is in, no one has a way to beat the market.