How our numbers driven world has transformed the business of investing—and how to take advantage of it.
There is a contentious debate among Wall Street’s finest regarding the right way to approach equities investing. Detailing what such a strategy would look like is difficult, but the technique would unquestionably need to evolve based on prevailing macro and micro trends. Pursuing a universal theory is a fool’s errand, but it is possible to minimize risk without employing elaborate hedging strategies. Most investing styles focus disproportionately on one side of the overall activity: quantitative valuation. From the Efficient Markets Hypothesis to fundamental analysis to even age-old philosophies describing risk, there are incredibly many notions percolating in the investing universe. These approaches are only partially useful, as they address only the quant side of what is a multi-faceted process. A more prudent method considers both the quality of the security in question and the widespread sentiment surrounding it, a duality that will be discussed here.
One of the most common investment theories is the Efficient Markets Hypothesis (EMH), which posits that all publicly available information about a company is priced into the current stock. Consequently, a legitimate price advantage cannot be sustained, as an investor will be perpetually tardy acting on the new developments (1). Broadly, the EMH’s strictest interpretation claims that all information, public and private “is fully and immediately factored into prices” (2). A key assumption of the EMH is that stock prices follow a random walk (3)—that is, [the] future path of the price level of a security is no more predictable than the "path of a series of cumulated random numbers” (4). The direct result of the EMH conclusion is that it is impossible to consistently value equities accurately. This defeatist view of the equities markets has come under intense scrutiny many times, and is still controversial decades after being published. In fact, the underpinning of the theory breaks down with some intuitive reasoning. The EMH is a paradoxical claim, for someone has to invest with the recent news for it to be reflected in the price—the value cannot spontaneously jump. Someone is profiting off this movement, meaning it is possible to exploit a momentary lapse in the lockstep relationship between information and share value.
However, the main thesis of the EMH—stating that equities follow a random walk—is a radical conclusion that erroneously overlooks market sentiment and irrationalities. The statistics underpinning the EMH and random walk theory are beyond the scope of this piece, but the implications of assuming an efficient market wherein prices move essentially randomly are relevant. The idea that a stock’s value is unpredictable and completely reflective of available intel is mathematically reasonable, but dubious upon consideration of the human element. The EMH presumes completely rational behavior from investors, a leap that simply cannot be justified. Emotion creeps into the decisions of even the most objective investor, a reality that cannot coexist with the utopian market with perfectly rational investments. The graph below (9) shows the three different ways a price reacts to news. Rarely does a security follow the suggested efficient response, because of market irrationalities or information asymmetries. On average, investors either overreact to the news, or fail to consider it immediately, opening up an opportunity for the savvy investor. The human element cannot be divorced from the decision-making process, an axiom that necessarily narrows the scope of the EMH to a purely theoretical view.
While the EMH is based on a statistical observation, fundamental analysis stresses the importance of a company’s financials. Fundamental analysis is endorsed in some form by notable figures as Warren Buffett and Joel Greenblatt, proponents of value investing. While there are legitimate drawbacks to this style, it is widely considered a proven strategy, largely because it emphasizes an apparently logical strategy—that a company’s true value can be determined from its financial statements. Even more, fundamental analysis claims that this information is actionable, or useful to make investing decisions. This is because of its tailored method of analyzing each company individually, weighing different factors for firms in different sectors or spaces. The company-specific information can be directly utilized when assessing an investment, whereas the EMH is a broad commentary on financial markets. There is however one variable that cannot be numerically represented, and that is investor sentiment and efficiency. The underlying premise in fundamental investing is that a company whose intrinsic value is higher than its current price is worth considering. Intrinsic value is a tricky subject, for every investor possesses his/her own technique to determine it, weighing tangible and intangible factors alike with different priorities. While there are obviously other forces at play that must be factored in, analysis of a company’s intrinsic value symbolizes the crux of the fundamental approach.
It is at this point where many investors fail to recognize what this technique inherently implies. Despite what the financials indicate, a company is undervalued only if there is a reason for bullish sentiment going forward. At some point, others will need to feel similarly about a company for the investment justification to be valid. This is an unreliable variable, as “investors in general may be inefficient in their fundamental analyses” (5). This is an important distinction that seems obvious, but is often overlooked in the numbers-driven world of finance. People have to share an optimistic outlook in order for something to appreciate, and in turn, to profit from that movement, one has to act before this view proliferates.
Before moving into a more advanced interpretation of equity risk, it is helpful to introduce the way risk has been analyzed for decades. Underestimating the significance of others’ actions and beliefs is adding an element of risk to a process of investing already rife with uncertainty. Yet, there are many more misconceptions surrounding the alluring business of investing. Perhaps the most recurring piece of ‘wisdom’ in investing literature is that risk and return share a direct relationship. The idea that higher risk leads to higher returns is echoed to the point of general acceptance. This conclusion is accurate when applied a single investment, but in a portfolio of positions, nothing could be further from the truth.
A common method of evaluating the return of a portfolio after adjusting for risk is the Sharpe Ratio. Devised by Nobel laureate William Sharpe, this metric considers the “change in a portfolio’s overall risk-return characteristics when [adding] new asset or asset class” (6). In other words, it describes the dynamic between the current portfolio and the proposed addition. Curiously, when adding an investment to a portfolio that contains “only low-risk assets, the addition of a risky asset can make it safer” (8). The figure below from Sharpe’s seminal paper depicts this counterintuitive statistical phenomenon.
The standard deviation of the proposed investment is a proxy for risk, and the vertical axis represents the statistical mean return as a function of the deviation. The X and Y lines are two different strategies in the previously referenced low-risk portfolio. The Y strategy is analogous to adding another low-risk security, while the X strategy is the infusion of a more volatile, risky investment. The X function has a greater slope (the slope of this line actually is the Sharpe Ratio), meaning it not only produces a higher average return at equivalent deviations, but also is a safer bet when mixed with the previously stable portfolio. Overall risk decreases as a result of how adding a risky security reduces the statistical correlation between the positions in the portfolio—in other words, it is a mathematical manifestation of how true portfolio diversification transcends industry sectors and asset classes and includes risk.
Wrapping up the technical portion of this piece, it is important to acknowledge the usefulness of these techniques in evaluating fragments of the investing puzzle. They can highlight a particular aspect of an investment opportunity, but they cannot provide a complete picture. None of these approaches yield actionable information singlehandedly. There is another half of the picture that any metric or philosophy ignores: the human component. A discussion on how to best value equities cannot neglect this factor, and thus investors’ emotion bias will be expatiated through their tendencies and misguided foundations.
Not one of the calculations or strategies matter if investor sentiment is not ideal. A security garnering widespread excitement can be the pitfall of the investor who disregards the important of buying at the right price. No matter the quality of the company or the underlying asset, buying at the wrong price is dangerous. This seems obvious. Nobody wants to invest in an overvalued security, but the difficulty lies in determining what exactly constitutes overvalued. A good rule of thumb is that the “price of an investment can be lower than it should be only when most people don’t see its merit” (8). Translation: avoid the crowds, for they inevitably portend a bloated price.
Moreover, many investors fail to recognize the distinction between investment risk and fundamental risk. Investment risk describes the uncertainty of a particular investment given it’s the relation between its current price and its true value. Fundamental risk, however, is directly proportional the quality of the security itself. A stable blue-chip company may have low fundamental risk while maintaining significant investment risk, if it is substantially overpriced. Much the same way, a company thought to be unproven or financially erratic can flash low investment risk. In fact, this unpredictable reversal of what is expected occurs more often than anticipated.
Blurring these two forms of risk is a grave error. Frequently, a security perceived to carry sizeable risk is left untouched, avoidance that drives its price down. There is critical point where despite the fundamental risk inherent to the underlying asset, the investment risk becomes microscopic—this is an inefficiency in the market produced largely by herd mentality. The same principle applies to investments typically considered ‘safe’. Stable companies are not necessarily the sanctuary many consider them to be. Recognizing the point at which the fundamental and investment risks diverge is a crucial first step towards realizing more consistent returns.
Investing will always entail some degree of chance, as presumed by the statistics underlying random walk theory and the EMH. Nonetheless, understanding the dynamic between a security’s current price and its true price is an essential first step to condense the world of investing possibilities into a more targeted group of securities that merit further consideration. Diagnosing the sentiment surrounding the investment is also crucial, as “the very coalescing of popular opinion behind an investment tends to eliminate its profit potential” (8). The counterintuitive nature of this kind of thinking can be difficult to grasp, especially with experts everywhere prattling off undervalued securities every day. Howard Marks, Chairman of Oaktree Capital, concludes that it’s “nonsensical to say…’everyone realizes that investment’s a bargain’” (8). This is a deeper analysis of how a price reflects both financial information and investor activity. While this appears to be an application of the EMH, the EMH precludes the possibility of any legitimate investments, a supposition that simply is not true.
It’s easy to forget how the markets operate. No matter the analysis or the number crunching, all investors are susceptible to others’ decisions. Exposing money to investments without adequately considering this paradigm and completing the corresponding two-sided due diligence is perilous. If you cannot invest the time to fully understand the market forces, it’s best to put your money in a safer asset class. Even investment professionals, on average, will obtain minimally higher gains. Even so, extra returns are often consumed by management fees in the end. The ease with which anyone can stake their money in the market today has led to a pervasive hubris largely resistant to volatility and crashes—the market’s primary warning signs. Dabbling in these complex securities is daring and often perpetuated by fluke gains. Sometimes it’s best to just take a step back and recognize how challenging it really is to maintain that competitive advantage.
1) Fama, Eugene F. “The Behavior of Stock-market Prices”. The Journal of Business 38.1 (1965): 34–105. Web.
2) "What Are the Primary Assumptions of Efficient Market Hypothesis?" Investopedia. Investopedia, LLC, 31 Mar. 2015. Web. 26 Oct. 2015.
3) Malkiel, Burton Gordon. A Random Walk down Wall Street. New York: Norton, 1973. Print.
4) Fama, Eugene F. "Random Walks in Stock Market Prices." Financial Analysts Journal 21.5 (1965): 55-59. Web.
5) Abarbanell, Jeffrey S., and Brian J. Bushee. "Fundamental Analysis, Future Earnings, and Stock Prices." Journal of Accounting Research 35.1 (1997): 1-25. JSTOR [JSTOR]. Web. 27 Oct. 2015.
6) "Sharpe Ratio Definition | Investopedia." Investopedia. Investopedia, LLC, 26 Nov. 2003. Web. 27 Oct. 2015.
7) Sharpe, William F. "The Sharpe Ratio." The Journal of Portfolio Management Portfolio Management 21.1 (1994): 49-58. Web. 27 Oct. 2015.
8) Marks, Howard. "Memos from Our Chairman." It's Not Easy 25 (9 Sept. 2015): n. pag.Oaktree Capital. Oaktree Capital Management, L.P., 9 Sept. 2015. Web. 18 Oct. 2015.
9) Efficient-markets Hypothesis. Digital image. Freerisk.org. Freerisk, n.d. Web. 28 Oct. 2015.