The secret to stock-market riches

By Martin Hesse Time of article published Nov 25, 2019

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That headline caught your eye, didn’t it? Now that I have your attention, I am afraid to tell you that you have been taken for a bit of a con. If I knew the secret to stock-market riches, you would not be reading this column right now, because it would not have been written. I would be lounging in a deckchair aboard my luxury yacht anchored off the Bahamas, sipping Dom Pérignon, marvelling at my good fortune, and wondering how it was that no-one before me had stumbled on my method.

And I certainly would not have let you, dear reader, in on the secret.

The point is there is no sure-fire way of making lots of money buying and selling shares over a short period. And if anyone tells you there is, he or she is a con artist, and not a very imaginative one at that.

Market analysts, who make an in-depth study of the financial markets, are not much closer to fathoming their capricious nature than you are. But the academics among them have formulated theories that do explain certain characteristics of stock markets, which investors may benefit from (or not).

The big question is whether or not markets are rational. Do investors buy and sell shares based on rational decisions, based on their knowledge of a company and the conditions under which it is operating, or are irrational factors, such as emotions - notably fear and greed - and cognitive biases, the drivers?

The answer is most definitely both - but which predominates, and when?

Technical analysts love charts. They look for patterns in a share graph that may indicate whether the share is likely to move down, up or sideways. While a technical analyst may consider other factors, he or she is primarily concerned with the psychology of investors, which manifests in the patterns.

Do they have any success? Some of them do, but it’s not the “instant riches” type of success promised in the headline. It’s a hard, long slog where perhaps they will be correct 55% of the time ... if they don’t let their own emotions and biases intervene.

The efficient market hypothesis

A theory of rational market activity, the efficient market hypothesis, emerged in the 1950s and 1960s based on work done by French mathematician Louis Bachelier around 1900. In essence it states that, if you have a large enough pool of investors, and all possible information about a company and the conditions under which it is trading is available to those investors, the share price of the company will fully reflect all that information and it will thus fairly represent the value of the company. Because any new information is immediately reflected in the share price, it is impossible for anyone to predict what the share price will do. And because the population is large enough, any individual errors will cancel each other out.

In a fascinating presentation at last month’s Morningstar Investment Conference, Daniel Needham, the president and chief investment officer of Morningstar Investment Management, suggested that while markets were frequently efficient, they were sometimes inefficient. Put another way, markets are rational except when they are irrational. An extreme example of irrationality is when there is a bubble or a crash - when share prices keep on going up or down for no logical reason.

Needham said a better way of describing the market is that it is a complex adaptive system. In such a system there is a high number of agents (investors) and a high number of interactions (communications and trades). The agents and the way they interact are not static: they adapt, learn, evolve. And the system takes on a life of its own - it is greater than the sum of its parts.

Most of the time, individual errors cancel each other out, and the “wisdom of the crowd” prevails. The higher the diversity of agents’ interactions, the lower the chance of collective error.

Needham illustrated this by asking the audience to express in months the gestation period of an elephant. While the answers were widely divergent, the average answer of 22.7 was very close to the correct answer of 22.

But sometimes a relatively small event can trigger a disproportionately large reaction in which the majority of agents forsake their independence irrationally to follow the herd. Needham says in cases such as these, the healthy balance of independence and interdependence is disrupted, and a behavioural bias known as the imitation heuristic predominates. “Markets are efficient when there is diversity and a big range of decision-making. They are inefficient when everyone copies each other,” he says.

So what should investors be doing? Needham says they should be on the alert for breakdowns in diversity - in other words, they should look for correlated behaviour - and then go against the herd. This contrarian approach is not the secret to instant riches, but it is a way of beating the market over time. He quoted the economist John Maynard Keynes, who said: “The central principle of investment is to go contrary to the general opinion, on the grounds that if everyone is agreed about its merit, the investment is inevitably too dear and therefore unattractive.”


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