Random walks and "on sale" stocks - confused
Random walks and "on sale" stocks - confused
Folks here (presumably those of pre-retirement age) often rejoice when stock prices fall. The logic for this, as I understand, is that cheaper stocks mean you can buy more shares for the same money. If you are a long-term investor, this is a good thing, I guess. I'm pretty sure Mr. Buffett has said something along these lines.
This doesn't jive with my mental model of the stock market, and I need y'all to help me out.
I view the market as a simple random walk - specifically, its expected growth is a more-or-less fixed number (at least for the foreseeable future?), but with noise over any given time period. The fact that the market dropped yesterday, or last month, or last year, is therefore irrelevant: we expect it to grow the same, regardless. Similarly, you would not predict a coin to flip heads after a run of 5 tails.
It therefore makes no sense to me that a long-term investor should be happy when stock prices fall. Whether they rose or fell last month should not change my expected return from the market in the future. The only thing that has happened is that my net worth has declined: a bad thing.
If you believe it is better to buy after a drop in price, then you must believe that the market is some mean reverting process, not strictly a random walk.
So what's going on? Is my model of the market totally off base? Is there some mean reverting process that I don't understand?
This doesn't jive with my mental model of the stock market, and I need y'all to help me out.
I view the market as a simple random walk - specifically, its expected growth is a more-or-less fixed number (at least for the foreseeable future?), but with noise over any given time period. The fact that the market dropped yesterday, or last month, or last year, is therefore irrelevant: we expect it to grow the same, regardless. Similarly, you would not predict a coin to flip heads after a run of 5 tails.
It therefore makes no sense to me that a long-term investor should be happy when stock prices fall. Whether they rose or fell last month should not change my expected return from the market in the future. The only thing that has happened is that my net worth has declined: a bad thing.
If you believe it is better to buy after a drop in price, then you must believe that the market is some mean reverting process, not strictly a random walk.
So what's going on? Is my model of the market totally off base? Is there some mean reverting process that I don't understand?
Re: Random walks and "on sale" stocks - confused
In my opinion, the downfall of most investors are behavioral. With the random walk theory you can't know if you made the correct decision until after the fact. That leaves people full of fear, uncertainty, and doubt. When the market falls that proves you made a wrong decision. Wrong, in the sense you did not have the good sense to foresee the future - which you can't. This wreaks havoc on one's emotional well being. One way to blunt the emotional trauma is the use the justification "I bought when the market was high, and that was wrong. But at least future purchases will be on sale." Which of course is post hoc justification.rbaldini wrote:It therefore makes no sense to me that a long-term investor should be "happy" when stock prices fall. Whether they rose or fell last month should not change my expected return from the market in the future. The only thing that has happened is that my net worth has declined: a bad thing.
Mind you, I am "ignore the noise" type of guy. I have built the best AA I can and a 5% drop in the market - or even 15% is going to significantly modify that AA.
Former brokerage operations & mutual fund accountant. I hate risk, which is why I study and embrace it.
Re: Random walks and "on sale" stocks - confused
Part of it is a matter of expectations that aren't quite clear.
If for example you assume that the S&P 500 will be at 5000 in two decades and are buying between now and then, you want the purchases to be at lower share prices. However, it is not clear that a 1% drop today doesn't in fact signify that the total cumulative return for the next two decades won't be something like 1% lower than we thought it would be yesterday. If we assume we have a random walk where each step is independent of the others, then a drop isn't a good thing as that doesn't change the expected value going forward.
That is, if your model is that the return over the next 20 years is going to be 6% annualized (or pick your number) then you want the sequence of returns that looks like J rather than the one that looks like Γ: more cheap buying opportunities for a given end result.
On a similar note, if you have the idea that you're actually interested in company fundamentals like book value and trust these more than the current price in the long run (I think Buffett would be more along these lines), then note that these things generally don't change as quickly as the stock price does. A company doesn't own 5% less hard assets if its stock price goes down 5%. However, perhaps a drop of 5% is a correct indication that the expected return from the business is correspondingly lower based on new information. It's hard to say.
Empirically, there seems to be a lot of evidence and hints that the market exhibits some serial correlation and otherwise doesn't act independently from one day to the next. If nothing else, check daily stock market standard deviation vs. yearly stock market standard deviation. The latter is lower than you would expect if you thought every day was independent. Furthermore, things seem to actively mean revert in the ~5 years territory. Not reliably, and some even dispute it's a thing at all, but you can check the data.
Furthermore, we can see that if a company uses some cash to buy back X dollars of stock or pay out X dollars of dividends (of which you get a cut and reinvest at the current stock price), the result is that you will own more of the company after the transaction the lower the stock price currently is. And obviously that's a good thing. If stocks are expensive, then you get less.
If for example you assume that the S&P 500 will be at 5000 in two decades and are buying between now and then, you want the purchases to be at lower share prices. However, it is not clear that a 1% drop today doesn't in fact signify that the total cumulative return for the next two decades won't be something like 1% lower than we thought it would be yesterday. If we assume we have a random walk where each step is independent of the others, then a drop isn't a good thing as that doesn't change the expected value going forward.
That is, if your model is that the return over the next 20 years is going to be 6% annualized (or pick your number) then you want the sequence of returns that looks like J rather than the one that looks like Γ: more cheap buying opportunities for a given end result.
On a similar note, if you have the idea that you're actually interested in company fundamentals like book value and trust these more than the current price in the long run (I think Buffett would be more along these lines), then note that these things generally don't change as quickly as the stock price does. A company doesn't own 5% less hard assets if its stock price goes down 5%. However, perhaps a drop of 5% is a correct indication that the expected return from the business is correspondingly lower based on new information. It's hard to say.
Empirically, there seems to be a lot of evidence and hints that the market exhibits some serial correlation and otherwise doesn't act independently from one day to the next. If nothing else, check daily stock market standard deviation vs. yearly stock market standard deviation. The latter is lower than you would expect if you thought every day was independent. Furthermore, things seem to actively mean revert in the ~5 years territory. Not reliably, and some even dispute it's a thing at all, but you can check the data.
Furthermore, we can see that if a company uses some cash to buy back X dollars of stock or pay out X dollars of dividends (of which you get a cut and reinvest at the current stock price), the result is that you will own more of the company after the transaction the lower the stock price currently is. And obviously that's a good thing. If stocks are expensive, then you get less.
Re: Random walks and "on sale" stocks - confused
Yeah, that was how I viewed it.However, it is not clear that a 1% drop today doesn't in fact signify that the total cumulative return for the next two decades won't be something like 1% lower than we thought it would be yesterday. If we assume we have a random walk where each step is independent of the others, then a drop isn't a good thing as that doesn't change the expected value going forward.
Fair enough, although for my *next* purchase, it doesn't matter.That is, if your model is that the return over the next 20 years is going to be 6% annualized (or pick your number) then you want the sequence of returns that looks like J rather than the one that looks like Γ: more cheap buying opportunities for a given end result.
Yeah, running the numbers for myself seems to make sense.Empirically, there seems to be a lot of evidence and hints that the market exhibits some serial correlation and otherwise doesn't act independently from one day to the next. If nothing else, check daily stock market standard deviation vs. yearly stock market standard deviation. The latter is lower than you would expect if you thought every day was independent. Furthermore, things seem to actively mean revert in the ~5 years territory. Not reliably, and some even dispute it's a thing at all, but you can check the data.
I just checked, and there is essentially no evidence of autocorrelation (it's about 4%, not significant) in either the annual or quarterly returns of VTSMX. I.e. losses last year/quarter are essentially independent of this year/quarter. That's only looking back to 1993, though. I'll look into more general statistical evidence for mean reversion soon, but that simple test suggests no. Of course, if you believe VTSMX is mean reverting, you shouldn't be invested in it right now...
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Re: Random walks and "on sale" stocks - confused
The way I'd conceptualise it is that the market values assets in terms of risk and return ... Take money lending: we demand higher interest for a longer term investment, and we demand higher interest for a riskier investmentrbaldini wrote:So what's going on? Is my model of the market totally off base? Is there some mean reverting process that I don't understand?
So an investment that promises a good return over a shorter time-scale is going to have additional value to investors, which is effectively taken out of the return
When markets are down, it means there are more people wanting to sell than to buy, which means you're buying when markets perceive some combination of increased risk and lower returns ... *Sometimes* when markets are down it's just lower returns you're buying into, which is why going on pricing alone isn't always helpful ... So we turn to valuations - and here's how closely US market valuations have predicted 10 year returns
"Economics is a method rather than a doctrine, an apparatus of the mind, a technique of thinking, which helps its possessor to draw correct conclusions." - John Maynard Keynes
Re: Random walks and "on sale" stocks - confused
Suppose the price of a company decreases below the value of the assets it holds, simply because of a lack of liquidity in the market. It sounds like you think that since prices are random, I should not expect there to be any greater chance for the price of such a company to increase than if the price of the company were 100x its assets. Why not?
Suppose I have a business that's fairly sure to return $1m/year far into the future. You can buy it for some price. Tomorow, the markets crash, and now you can buy it for half that price, even though the business is the same. How could that not be a better deal for you?
Suppose I have a business that's fairly sure to return $1m/year far into the future. You can buy it for some price. Tomorow, the markets crash, and now you can buy it for half that price, even though the business is the same. How could that not be a better deal for you?
Re: Random walks and "on sale" stocks - confused
Check a much longer data set, like from Kenneth French:rbaldini wrote:I just checked, and there is essentially no evidence of autocorrelation (it's about 4%, not significant) in either the annual or quarterly returns of VTSMX. I.e. losses last year/quarter are essentially independent of this year/quarter. That's only looking back to 1993, though. I'll look into more general statistical evidence for mean reversion soon, but that simple test suggests no. Of course, if you believe VTSMX is mean reverting, you shouldn't be invested in it right now...
http://mba.tuck.dartmouth.edu/pages/fac ... brary.html
http://mba.tuck.dartmouth.edu/pages/fac ... rs_TXT.zip
(MKT-RF is market minus risk-free rate, or the return of the stock market minus t-bills)
That's monthly data since 1926.
I admit to having never run the numbers myself but if anything there seems to be slightly positive autocorrelation with relatively low lags like around 1 year but slightly negative around several years.
Re: Random walks and "on sale" stocks - confused
This isn't a model of the market that I'm used to. Your "$1m/year business" analogy suggests a model in which my return depends only on the number of shares I own - not how much money I put in. I.e., my return after t years isbonn wrote:Suppose the price of a company decreases below the value of the assets it holds, simply because of a lack of liquidity in the market. It sounds like you think that since prices are random, I should not expect there to be any greater chance for the price of such a company to increase than if the price of the company were 100x its assets. Why not?
Suppose I have a business that's fairly sure to return $1m/year far into the future. You can buy it for some price. Tomorow, the markets crash, and now you can buy it for half that price, even though the business is the same. How could that not be a better deal for you?
t*R*n
where R is the annual return per share (in $ - the analog to the fixed $1m in your example) and n is the number of shares. So my return divided by the purchase cost is
t*R*n/(c*n) = t*R/c
where c is the cost per share. That is, the amount you get is inversely proportional to the share price, and so you get a better return if you buy when prices are very low. Note that this return is linear in time, not exponential - not something I'm used to seeing.
In contrast, every model I've seen assumes an average rate r>0 such that my total return is
(n*c)*(1+r)^t
Here, (n*c) is the amount invested. The total return divided by the original investment cost is then just
(1+r)^t
which does not depend on the share price. In this model, you get the same return, regardless of how many shares your original investment bought.
Is the latter model not right?
Re: Random walks and "on sale" stocks - confused
The first model fits a perpetual bond. Suppose you could buy a security that paid you $1 million a year every year for eternity. How much would such a thing fetch on the market? Whatever that is, it supplies a certain rate of return. And if you can buy it at a discount, the rate of return is higher.
The stock market, what with different companies being created and some going bankrupt, kind of continues in perpetuity like that. Or at least for a long time. And along the way, it has a certain amount of earnings (per share). Analogously, you can look at dividends (per share) that are paid out and compare the cash flows to the perpetual bond example. In practice dividends usually increase over time and the growth is not consistent from year to year but this is roughly the same thing. You would rather pay $15 to get $1 a year than $20 to get $1 a year.
In both cases that supposes that the income or earnings are not dependent on the price paid, as you point out.
A change in stock price doesn't actually reflect an underlying change in the business and its future earnings, so a lower price just means you're buying the same product at a lower price. It might sometimes or frequently represent a change in the anticipated future prospects of the company (the previous estimates being too optimistic or pessimistic and have been revised), but even that's not necessarily true. If nothing else, you're getting a discount on the price you pay for your share of future earnings. And if the long-term price is not (directly) related to the current price but rather to company fundamentals in the future, a lower price now isn't a handicap. We don't expect that somebody in 2030 will care that stock X declined 10% on a snowy day in January 2016 and will only accept a price of 0.9 * Y instead of Y, where Y is the actual price in 2030, because the value of that stock is not really influenced by whatever people were trading for it in the past.
It's not like you have (n*c) money invested and then take a trip to the RNG and draw a multiplicative factor every day for your return.
The stock market, what with different companies being created and some going bankrupt, kind of continues in perpetuity like that. Or at least for a long time. And along the way, it has a certain amount of earnings (per share). Analogously, you can look at dividends (per share) that are paid out and compare the cash flows to the perpetual bond example. In practice dividends usually increase over time and the growth is not consistent from year to year but this is roughly the same thing. You would rather pay $15 to get $1 a year than $20 to get $1 a year.
In both cases that supposes that the income or earnings are not dependent on the price paid, as you point out.
A change in stock price doesn't actually reflect an underlying change in the business and its future earnings, so a lower price just means you're buying the same product at a lower price. It might sometimes or frequently represent a change in the anticipated future prospects of the company (the previous estimates being too optimistic or pessimistic and have been revised), but even that's not necessarily true. If nothing else, you're getting a discount on the price you pay for your share of future earnings. And if the long-term price is not (directly) related to the current price but rather to company fundamentals in the future, a lower price now isn't a handicap. We don't expect that somebody in 2030 will care that stock X declined 10% on a snowy day in January 2016 and will only accept a price of 0.9 * Y instead of Y, where Y is the actual price in 2030, because the value of that stock is not really influenced by whatever people were trading for it in the past.
It's not like you have (n*c) money invested and then take a trip to the RNG and draw a multiplicative factor every day for your return.
Re: Random walks and "on sale" stocks - confused
I need to study up on how things *actually* work, because this is basically how I imagine the market working...lack_ey wrote: It's not like you have (n*c) money invested and then take a trip to the RNG and draw a multiplicative factor every day for your return.
Re: Random walks and "on sale" stocks - confused
I have been a financial quant for almost 20 years and have the same thought as you -- that a market drop is not something to rejoice about. Lots of Bogleheads are confused and irrational on this issue, simultaneously believing in the random walk theory and that it is better to buy stocks afte they have fallen.rbaldini wrote:Folks here (presumably those of pre-retirement age) often rejoice when stock prices fall. The logic for this, as I understand, is that cheaper stocks mean you can buy more shares for the same money. If you are a long-term investor, this is a good thing, I guess. I'm pretty sure Mr. Buffett has said something along these lines.
This doesn't jive with my mental model of the stock market, and I need y'all to help me out.
Re: Random walks and "on sale" stocks - confused
rbaldini wrote:Folks here (presumably those of pre-retirement age) often rejoice when stock prices fall. The logic for this, as I understand, is that cheaper stocks mean you can buy more shares for the same money. If you are a long-term investor, this is a good thing, I guess. I'm pretty sure Mr. Buffett has said something along these lines.
This doesn't jive with my mental model of the stock market, and I need y'all to help me out.
If price drops were strictly a result of PE contractions (same growth prospects just lower PE), you can say they are on sale and gamble at some point that they will go back to past levels. But if the price drop is from growth that isn't happening, it isn't clear you have any chance of getting that back. That is just lost time. Obviously these are both very, very high level statements.
There is no way to know if the stocks are on sale or if they are distressed merchandise. Or heck maybe the old price was just inflated and now we are at the new standard price. It is a mental trick to make them feel better about losing money.
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Re: Random walks and "on sale" stocks - confused
It can be viewed as a simple random walk ON TOP OF an upward trend. If you catch the random walk at a lower point, you will make more money over time. Remember that random walk is the time-integral of white noise, so refers to the variance growth over time, not the underlying trend.rbaldini wrote: I view the market as a simple random walk - specifically, its expected growth is a more-or-less fixed number (at least for the foreseeable future?), but with noise over any given time period. The fact that the market dropped yesterday, or last month, or last year, is therefore irrelevant: we expect it to grow the same, regardless. Similarly, you would not predict a coin to flip heads after a run of 5 tails.
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Re: Random walks and "on sale" stocks - confused
I think the key points you are missing here are:rbaldini wrote:I need to study up on how things *actually* work, because this is basically how I imagine the market working...lack_ey wrote:It's not like you have (n*c) money invested and then take a trip to the RNG and draw a multiplicative factor every day for your return.
1) Nobody knows "how things actually work."
2) People who post to the Bogleheads forum think things that are inconsistent with each other. People who self-identify as "Bogleheads" following "the Boglehead philosophy" are inconsistent with each other. The same person is inconsistent from one time to another. And an individual person can easily flip between contradictory thoughts without noticing they are doing it... or can hold two contradictory thoughts simultaneously.
3) Generally people don't like it when the stock market falls, so some people enjoy sounding sophisticated, tough-minded, and contrarian by saying how much they love it when the stock market falls.
Watch out for sound bites and slogans. They are always contradictory, nobody can ever say precisely what they mean, they are unfalsifiable, they are often used to convince people to do something, and they pollute the mind with pernicious garbage. Some examples, which I am going to intentionally list in alternating, contradictory order:
1) Buy when there's blood in the streets.
2) Nobody ever went broke taking a profit.
3) Cut your losses and let your profits run.
4) Be fearful when others are greedy and greedy when others are fearful.
5) Don't try to catch a falling knife.
6) Buy low, sell high.
7) Rule #1: don't ever lose money. Rule #2: don't ever forget rule #1.
8) Don't fight the dominant trend of the market.
9) Mean reversion!
10) Momentum!
11) What goes up must come down.
12) The trend is your friend.
Needless to say if someone says "buy when there's blood in the streets" and you buy and incur a terrible loss, they will say "oh, you messed up, there wasn't really blood in the streets, you need to wait for the real blood."
If you are about to do something and you realize that you are thinking about some pithy maxim... or that the convincer was that you heard someone say one of those pithy maxims... stop right away and do not act.
Last edited by nisiprius on Sat Jan 09, 2016 6:41 am, edited 1 time in total.
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Re: Random walks and "on sale" stocks - confused
Some of the thoughts in this thread are absurd.
If one had a choice, is it better to buy equities at the end of day when they have gone up 3% or at the end of a day when they have gone down 3%?
Or if one is going to buy stocks on a given day, was it better to buy them first thing in the morning before they went up 3% or to buy them late in the afternoon after they have already gone up 3%?
Or if one is going to buy stocks on a given day, was it better to buy them first thing in the morning before they go down 3% or to buy them late in the afternoon after they have already dropped 3%?
Random walk has nothing to do with this. And clearly, I am not writing about waiting for drops or pops to happen because they are not predictable.
I am reminded of those jokes about economists who see a $20 bill on the sidewalk.
If one had a choice, is it better to buy equities at the end of day when they have gone up 3% or at the end of a day when they have gone down 3%?
Or if one is going to buy stocks on a given day, was it better to buy them first thing in the morning before they went up 3% or to buy them late in the afternoon after they have already gone up 3%?
Or if one is going to buy stocks on a given day, was it better to buy them first thing in the morning before they go down 3% or to buy them late in the afternoon after they have already dropped 3%?
Random walk has nothing to do with this. And clearly, I am not writing about waiting for drops or pops to happen because they are not predictable.
I am reminded of those jokes about economists who see a $20 bill on the sidewalk.
Re: Random walks and "on sale" stocks - confused
Great reply. I think you hit the nail right on the head!alex_686 wrote:In my opinion, the downfall of most investors are behavioral. With the random walk theory you can't know if you made the correct decision until after the fact. That leaves people full of fear, uncertainty, and doubt. When the market falls that proves you made a wrong decision. Wrong, in the sense you did not have the good sense to foresee the future - which you can't. This wreaks havoc on one's emotional well being. One way to blunt the emotional trauma is the use the justification "I bought when the market was high, and that was wrong. But at least future purchases will be on sale." Which of course is post hoc justification.rbaldini wrote:It therefore makes no sense to me that a long-term investor should be "happy" when stock prices fall. Whether they rose or fell last month should not change my expected return from the market in the future. The only thing that has happened is that my net worth has declined: a bad thing.
Mind you, I am "ignore the noise" type of guy. I have built the best AA I can and a 5% drop in the market - or even 15% is going to significantly modify that AA.
Also, Nisprius post should win some kind of award! I should print this out for future reference.
Choose Simplicity ~ Stay the Course!! ~ Press on Regardless!!!
Re: Random walks and "on sale" stocks - confused
Read some threads from 2009. You may want to rethink your premise.rbaldini wrote:Folks here (presumably those of pre-retirement age) often rejoice when stock prices fall.
bogleheads.org 30085
Re: Random walks and "on sale" stocks - confused
Random walks are frequently associated with the efficient market hypothesis, whereas the concept of purchasing stocks on sale is implicitly based on a value-investing paradigm. The reason it doesn't "jive" is because they are different models of the stock market to begin with.
You should do some reading about value investing if you're interested in some of the differences between these two models - some of the descriptions of the value paradigm in the original post are false. With value investing, the stock isn't "mean-reverting". A stock that has lost 50% of its value because of genuine fundamental failures (e.g. substantial R&D that doesn't work out, structural shifts in the industry, etc.) may still be too expensive. Likewise, a stock that has appreciated by 50% may still be too cheap, according to a value paradigm. The difference between the investor's calculation of intrinsic value and the stock's trading/market value determines the expected return, not some historic mean.
In fact, value investors will say that the idea of mean reversion makes no sense. Take a company like Amazon for instance, why should its mean over the first two decades of its existence, when it was a very different type of company, have any predictive value at all? Or if it is a market/sector/industry mean, why should Amazon follow that mean given its different business strategies or competitive advantages?
At the heart of all of this lies a fundamental disagreement about whether math or accounting better captures investment and business reality.
You should do some reading about value investing if you're interested in some of the differences between these two models - some of the descriptions of the value paradigm in the original post are false. With value investing, the stock isn't "mean-reverting". A stock that has lost 50% of its value because of genuine fundamental failures (e.g. substantial R&D that doesn't work out, structural shifts in the industry, etc.) may still be too expensive. Likewise, a stock that has appreciated by 50% may still be too cheap, according to a value paradigm. The difference between the investor's calculation of intrinsic value and the stock's trading/market value determines the expected return, not some historic mean.
In fact, value investors will say that the idea of mean reversion makes no sense. Take a company like Amazon for instance, why should its mean over the first two decades of its existence, when it was a very different type of company, have any predictive value at all? Or if it is a market/sector/industry mean, why should Amazon follow that mean given its different business strategies or competitive advantages?
At the heart of all of this lies a fundamental disagreement about whether math or accounting better captures investment and business reality.
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Re: Random walks and "on sale" stocks - confused
I've noticed a fair bit of rationalization and irrational euphoria around this too. By all means, be happy if you happen to get some cash flow at a time when you can put into the market when prices are low, but explicitly wishing for a drop is perverse: a drop means the equities you already owned are now worth less. This is generally the exact opposite of what we want.Beliavsky wrote: I have been a financial quant for almost 20 years and have the same thought as you -- that a market drop is not something to rejoice about. Lots of Bogleheads are confused and irrational on this issue, simultaneously believing in the random walk theory and that it is better to buy stocks afte they have fallen.
About the only good thing I can see in this rationalization is that it may make it easier for people to stick to their AA, as opposed to panicking. Then again, it may also lead them to do suboptimal things like dollar cost averaging or keeping sums of idle cash on the sidelines and out of the market in the hope of capitalizing on a drop (ie. timing the market).
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Re: Random walks and "on sale" stocks - confused
Here's way to think about it
First, market doesn't move randomly, it moves randomly with up bias.
Second, when market falls it then moves randomly from there, with an upward bias.
Third, valuations do matter, so if market falls and it's because valuations have fallen (not earnings falling) then you have higher earnings yield and thus higher expected returns from then on. It's the higher expected returns you get when valuations fall that is why Buffett recommends that if you cannot resist market timing than at least be a buyer when others are panicky (so you at least have high expected returns when you buy) and be nervous when others are greedy (so you at least sell when expected returns now lower).
One last thing, markets do not move purely randomly as short term momentum is well documented.
Larry
First, market doesn't move randomly, it moves randomly with up bias.
Second, when market falls it then moves randomly from there, with an upward bias.
Third, valuations do matter, so if market falls and it's because valuations have fallen (not earnings falling) then you have higher earnings yield and thus higher expected returns from then on. It's the higher expected returns you get when valuations fall that is why Buffett recommends that if you cannot resist market timing than at least be a buyer when others are panicky (so you at least have high expected returns when you buy) and be nervous when others are greedy (so you at least sell when expected returns now lower).
One last thing, markets do not move purely randomly as short term momentum is well documented.
Larry
Re: Random walks and "on sale" stocks - confused
OK, color me monumentally "confused and irrational" here.Beliavsky wrote:I have been a financial quant for almost 20 years and have the same thought as you -- that a market drop is not something to rejoice about. Lots of Bogleheads are confused and irrational on this issue, simultaneously believing in the random walk theory and that it is better to buy stocks afte they have fallen.rbaldini wrote:Folks here (presumably those of pre-retirement age) often rejoice when stock prices fall. The logic for this, as I understand, is that cheaper stocks mean you can buy more shares for the same money. If you are a long-term investor, this is a good thing, I guess. I'm pretty sure Mr. Buffett has said something along these lines.
This doesn't jive with my mental model of the stock market, and I need y'all to help me out.
That there is any doubt that valuations affect future returns is, quite frankly, mind-boggling to me.
Try this experiment:
1) Go to M*, type in VTSAX, then click on the "Chart" tab. (You can delete the two default indexes that are automatically populated on the chart for comparison by hovering over their names and clicking the "x" boxes — keep it simple and isolate the total stock market index fund.)
2) If the chart doesn't start with it by default, click on the 10 year ("10Y") zoom option, and marvel at the volatility.
3) Go to the start date box (it will be showing "01/09/2006"), and edit it to: "09/12/2008" and use the "Tab" key on your keyboard to activate your entry.
4) Note the "growth" value: $18,184.82. That's how much a $10,000 investment on the starting date would be worth on the ending date (yesterday). That represents an 81.84% total return in a little over 8 years.
5) Now edit the start date box to one month later: "10/12/2008."
6) Note the "growth" value: $25,301.13. That's how much a $10,000 investment on the starting date would be worth on the ending date (yesterday). That represents an 153.01% total return in a little over 8 years.
So the question is, which date was better for entry into the market?
I'm 100% with you on this one, livesoft!livesoft wrote:Some of the thoughts in this thread are absurd.
If one had a choice, is it better to buy equities at the end of day when they have gone up 3% or at the end of a day when they have gone down 3%?
Or if one is going to buy stocks on a given day, was it better to buy them first thing in the morning before they went up 3% or to buy them late in the afternoon after they have already gone up 3%?
Or if one is going to buy stocks on a given day, was it better to buy them first thing in the morning before they go down 3% or to buy them late in the afternoon after they have already dropped 3%?
Random walk has nothing to do with this. And clearly, I am not writing about waiting for drops or pops to happen because they are not predictable.
I am reminded of those jokes about economists who see a $20 bill on the sidewalk.
(As a side note, if folks have such trouble seeing how purchase prices affect future returns, it's no wonder they have such difficulty understanding the purpose and real life value of DCA, which is all about diversifying purchase prices.)
"Discipline matters more than allocation.” |—| "In finance, if you’re certain of anything, you’re out of your mind." ─William Bernstein
- Maynard F. Speer
- Posts: 2139
- Joined: Wed Mar 18, 2015 10:31 am
Re: Random walks and "on sale" stocks - confused
iceport wrote:That there is any doubt that valuations affect future returns is, quite frankly, mind-boggling to me.
Absolutely - but of course, if you accept markets are not insignificantly inefficient (someone else's wording), then prices can mislead either way
Here's a UK example:
- Marlborough Micro-Cap Growth up 110% over 5 years
- BlackRock Gold and Mining down 65% over 5 years
Yet a crude look at valuations shows that despite actually 10 years of wildly diverging prices, the gold and mining fund is still ostensibly more expensive:
Marlborough:
P/E : 12.05
Grwth : 19.17
BlackRock:
P/E : 24.72
Grwth : 12.04
So, for me, principles of DCA and rebalancing are only half-effective for the intended purpose of 'buying cheap and selling expensive', and are better thought of as risk control measures ... If I were selling Micro-cap stocks to top up an allocation to mining stocks, I'd (potentially) still be selling low and buying high
"Economics is a method rather than a doctrine, an apparatus of the mind, a technique of thinking, which helps its possessor to draw correct conclusions." - John Maynard Keynes
Re: Random walks and "on sale" stocks - confused
That seems correct. My perception has been that, with respect to broad market indexes, any mis-pricing tends to amplify the extremes. Very high valuations seem to have led to inappropriately high prices, and very low valuations have led to inappropriately low prices.Maynard F. Speer wrote:iceport wrote:That there is any doubt that valuations affect future returns is, quite frankly, mind-boggling to me.
Absolutely - but of course, if you accept markets are not insignificantly inefficient (someone else's wording), then prices can mislead either way
This also seems correct. (I should not have brought DCA into this thread so as not to conflate the issues, but I couldn't resist.)Maynard F. Speer wrote:So, for me, principles of DCA and rebalancing are only half-effective for the intended purpose of 'buying cheap and selling expensive', and are better thought of as risk control measures ...
"Discipline matters more than allocation.” |—| "In finance, if you’re certain of anything, you’re out of your mind." ─William Bernstein
Re: Random walks and "on sale" stocks - confused
Backing up a bit...
If the returns for each day were truly independent then nobody should like a drop. The reality is that they aren't, at least in certain ways. Or at least a significant number of people think this.
Even if returns are not independent, it matters why the price changed, and some who rejoice automatically are probably fooling themselves or just putting a spin on things. If stock prices go down because real bond yields went up and people have decent alternatives to stocks, that probably indicates greater expected returns on everything and is a good thing. If stock prices go down because the future is murkier, big risks are looming on the horizon, and the expectations of future earnings have crashed then the change is probably not anything to be excited about. If an individual stock goes down just because a big mutual fund wants to unload millions upon millions of shares in order to free up money to buy something else and isn't finding enough buyers, this price depression is probably temporary anyway. In any case, on a daily basis the "why" is generally a combination of multiple things and impossible to truly disentangle and figure out so I wouldn't necessarily be too excited.
I personally don't think it's worth hoping or being excited one way or the other.
If the returns for each day were truly independent then nobody should like a drop. The reality is that they aren't, at least in certain ways. Or at least a significant number of people think this.
Even if returns are not independent, it matters why the price changed, and some who rejoice automatically are probably fooling themselves or just putting a spin on things. If stock prices go down because real bond yields went up and people have decent alternatives to stocks, that probably indicates greater expected returns on everything and is a good thing. If stock prices go down because the future is murkier, big risks are looming on the horizon, and the expectations of future earnings have crashed then the change is probably not anything to be excited about. If an individual stock goes down just because a big mutual fund wants to unload millions upon millions of shares in order to free up money to buy something else and isn't finding enough buyers, this price depression is probably temporary anyway. In any case, on a daily basis the "why" is generally a combination of multiple things and impossible to truly disentangle and figure out so I wouldn't necessarily be too excited.
I personally don't think it's worth hoping or being excited one way or the other.
You're supposing that the final value is set, which it is with the benefit of hindsight. It's different when you encounter gains and losses in real time.iceport wrote:OK, color me monumentally "confused and irrational" here.
That there is any doubt that valuations affect future returns is, quite frankly, mind-boggling to me.
Try this experiment:
1) Go to M*, type in VTSAX, then click on the "Chart" tab. (You can delete the two default indexes that are automatically populated on the chart for comparison by hovering over their names and clicking the "x" boxes — keep it simple and isolate the total stock market index fund.)
2) If the chart doesn't start with it by default, click on the 10 year ("10Y") zoom option, and marvel at the volatility.
3) Go to the start date box (it will be showing "01/09/2006"), and edit it to: "09/12/2008" and use the "Tab" key on your keyboard to activate your entry.
4) Note the "growth" value: $18,184.82. That's how much a $10,000 investment on the starting date would be worth on the ending date (yesterday). That represents an 81.84% total return in a little over 8 years.
5) Now edit the start date box to one month later: "10/12/2008."
6) Note the "growth" value: $25,301.13. That's how much a $10,000 investment on the starting date would be worth on the ending date (yesterday). That represents an 153.01% total return in a little over 8 years.
So the question is, which date was better for entry into the market?
- Maynard F. Speer
- Posts: 2139
- Joined: Wed Mar 18, 2015 10:31 am
Re: Random walks and "on sale" stocks - confused
Well I think you're absolutely right - and when you're investing in a single, efficient market (like the US), apart from occasional over and undershooting, DCA and rebalancing probably do a pretty good job of ensuring you're buying and selling the right way around .. I picked the most extreme example I could think of, in what's probably a less efficient marketiceport wrote:That seems correct. My perception has been that, with respect to broad market indexes, any mis-pricing tends to amplify the extremes. Very high valuations seem to have led to inappropriately high prices, and very low valuations have led to inappropriately low prices.Maynard F. Speer wrote:iceport wrote:That there is any doubt that valuations affect future returns is, quite frankly, mind-boggling to me.
Absolutely - but of course, if you accept markets are not insignificantly inefficient (someone else's wording), then prices can mislead either wayThis also seems correct. (I should not have brought DCA into this thread so as not to conflate the issues, but I couldn't resist.)Maynard F. Speer wrote:So, for me, principles of DCA and rebalancing are only half-effective for the intended purpose of 'buying cheap and selling expensive', and are better thought of as risk control measures ...
But I think when valuations really diverge beyond prices (e.g. when bonds looked much cheaper than stocks in the 90s) there could be an argument for tactically shifting asset allocations
"Economics is a method rather than a doctrine, an apparatus of the mind, a technique of thinking, which helps its possessor to draw correct conclusions." - John Maynard Keynes
Re: Random walks and "on sale" stocks - confused
You can reinvest the profit, so the model is exponential in both cases. Since you get twice the shares if you put in twice the money (at whatever price), your return does depend linearly on how much money you put in at a given point in time in both cases. The first model then becomes a special case of the latter one if you make r a function of share price. Since valuation does predict return 10 years ahead in time (even if imperfectly), return does correlate to share price, so there you go.rbaldini wrote:This isn't a model of the market that I'm used to. Your "$1m/year business" analogy suggests a model in which my return depends only on the number of shares I own - not how much money I put in. I.e., my return after t years isbonn wrote:Suppose the price of a company decreases below the value of the assets it holds, simply because of a lack of liquidity in the market. It sounds like you think that since prices are random, I should not expect there to be any greater chance for the price of such a company to increase than if the price of the company were 100x its assets. Why not?
Suppose I have a business that's fairly sure to return $1m/year far into the future. You can buy it for some price. Tomorow, the markets crash, and now you can buy it for half that price, even though the business is the same. How could that not be a better deal for you?
t*R*n
where R is the annual return per share (in $ - the analog to the fixed $1m in your example) and n is the number of shares. So my return divided by the purchase cost is
t*R*n/(c*n) = t*R/c
where c is the cost per share. That is, the amount you get is inversely proportional to the share price, and so you get a better return if you buy when prices are very low. Note that this return is linear in time, not exponential - not something I'm used to seeing.
In contrast, every model I've seen assumes an average rate r>0 such that my total return is
(n*c)*(1+r)^t
Here, (n*c) is the amount invested. The total return divided by the original investment cost is then just
(1+r)^t
which does not depend on the share price. In this model, you get the same return, regardless of how many shares your original investment bought.
Is the latter model not right?
But in any case, for this business, suppose you won't be selling it and that it really will give you predictable profits. In that case, how can your return not depend on share price? For a fixed sum to invest, it's the only variable. If you had enough money to buy half the company, but now the price is cut in half, so you can buy the whole company, your return will be double.
Return varies with time and that doesn't by itself violate the EMH, as far as I know. The period after a crash is/can be a period of higher return. Unless you think you can predict crashes better than the market itself can, I don't see how that violates the EMH? It seems to me like saying that if interest rate increases cause bond returns to increase, then that violates the EMH. Maybe I'm not understanding the argument here?
- TheTimeLord
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- Joined: Fri Jul 26, 2013 2:05 pm
Re: Random walks and "on sale" stocks - confused
Are you sure? Let's say you are going to flip a coin 1,000 times and the first 6 flips are heads do yourbaldini wrote: Similarly, you would not predict a coin to flip heads after a run of 5 tails.
A) Think this is a statistically meaningfully event that has now had an affect on the outcome of the 1,000 flips and I should adjust my prediction of the results accordingly
B) Think this is part of the random nature of flipping a coin and it is likely it will even out over the 1,000 flips
If you think B then you are assigning a slight statistical advantage to tails based on the previous 6 flips.
Is there anything less likely in a 1,000 coin flips than one exact given order for example alternating heads and tails throughout the entire 1,000 flips?
IMHO, Investing should be about living the life you want, not avoiding the life you fear. |
Run, You Clever Boy! [9085]
- Epsilon Delta
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Re: Random walks and "on sale" stocks - confused
If you know stocks will be down it is better to short early and cover late. If you are not writing about waiting for drops or pops what are you talking about?livesoft wrote:Some of the thoughts in this thread are absurd.
If one had a choice, is it better to buy equities at the end of day when they have gone up 3% or at the end of a day when they have gone down 3%?
Or if one is going to buy stocks on a given day, was it better to buy them first thing in the morning before they went up 3% or to buy them late in the afternoon after they have already gone up 3%?
Or if one is going to buy stocks on a given day, was it better to buy them first thing in the morning before they go down 3% or to buy them late in the afternoon after they have already dropped 3%?
Random walk has nothing to do with this. And clearly, I am not writing about waiting for drops or pops to happen because they are not predictable.
I am reminded of those jokes about economists who see a $20 bill on the sidewalk.
As has been pointed out if the market is a random walk what you discuss is noise and fury signifying nothing. If the market isn't a random walk what is it?
Re: Random walks and "on sale" stocks - confused
I don't see it that way. Speaking in very general terms (and, again, about broad market index funds), no matter where the market ends up on any given future date, your returns will be better on the shares you buy after a market drop large enough to cause widespread concern than on the shares you bought soon before such a drop.lack_ey wrote:You're supposing that the final value is set, which it is with the benefit of hindsight. It's different when you encounter gains and losses in real time.
Edit: I'm fairly simple-minded, so maybe that's my problem here. I just don't understand why what I wrote above is not obvious to all...
Last edited by iceport on Sat Jan 09, 2016 11:52 am, edited 2 times in total.
"Discipline matters more than allocation.” |—| "In finance, if you’re certain of anything, you’re out of your mind." ─William Bernstein
Re: Random walks and "on sale" stocks - confused
I don't think the market follows a random walk, although modeling it as one is an interesting exercise that can yield some useful insights. If the market truly were random, why would anyone invest in it? Why not just go to Las Vegas where the shows are better?
Re: Random walks and "on sale" stocks - confused
A random walk that's generalized to be upward biased in some way, obviously (or just a random walk on top of an upward moving process, whatever you prefer). Is that what you're talking about or were you thinking about the case where the expected return is zero?telemark wrote:I don't think the market follows a random walk, although modeling it as one is an interesting exercise that can yield some useful insights. If the market truly were random, why would anyone invest in it? Why not just go to Las Vegas where the shows are better?
Re: Random walks and "on sale" stocks - confused
Actually, if I assume that the coin is a fair coin despite the run of 6 heads, I assume that after 1,000 flips, I should now expect 503 heads and 497 tails. There is no reason to expect reversion to the mean if each is an independent trial.TheTimeLord wrote:Are you sure? Let's say you are going to flip a coin 1,000 times and the first 6 flips are heads do yourbaldini wrote: Similarly, you would not predict a coin to flip heads after a run of 5 tails.
A) Think this is a statistically meaningfully event that has now had an affect on the outcome of the 1,000 flips and I should adjust my prediction of the results accordingly
B) Think this is part of the random nature of flipping a coin and it is likely it will even out over the 1,000 flips
If you think B then you are assigning a slight statistical advantage to tails based on the previous 6 flips.
Is there anything less likely in a 1,000 coin flips than one exact given order for example alternating heads and tails throughout the entire 1,000 flips?
Market returns, though, are not independent trials. In the short term, there is serial correlation (momentum) with an element of randomness; in the long-term, valuations matter.
As Benjamin Graham put it, “In the short run, the market is a voting machine but in the long run, it is a weighing machine.”
That's why, if I held an individual stock, I would probably feel an idiosyncratic loss as real, because it would reflect a real diminution in value. But with broad indexes and general market movements, I may not feel like the loss is real, because if I don't feel like it reflects a real reduction in long-term economic value. In that case, as an accumulator, I won't fret over short-term drops.
Last edited by jhfenton on Sat Jan 09, 2016 11:53 am, edited 1 time in total.
- TheTimeLord
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Re: Random walks and "on sale" stocks - confused
You are correct and yet the most unlikely of events is a strict alternating of flips throughout the rest of the test meaning your expectations will constantly be readjusted to other predictions.jhfenton wrote:Actually, if I assume that the coin is a fair coin despite the run of 6 heads, I assume that after 1,000 flips, I should now expect 503 heads and 497 tails. There is no reason to expect reversion to the mean if each is an independent trial.TheTimeLord wrote:Are you sure? Let's say you are going to flip a coin 1,000 times and the first 6 flips are heads do yourbaldini wrote: Similarly, you would not predict a coin to flip heads after a run of 5 tails.
A) Think this is a statistically meaningfully event that has now had an affect on the outcome of the 1,000 flips and I should adjust my prediction of the results accordingly
B) Think this is part of the random nature of flipping a coin and it is likely it will even out over the 1,000 flips
If you think B then you are assigning a slight statistical advantage to tails based on the previous 6 flips.
Is there anything less likely in a 1,000 coin flips than one exact given order for example alternating heads and tails throughout the entire 1,000 flips?
Market returns, though, are not independent trials. In the short term, there is serial correlation (momentum) with an element of randomness; in the long-term, valuations matter.
As Benjamin Graham put it, “In the short run, the market is a voting machine but in the long run, it is a weighing machine.”
IMHO, Investing should be about living the life you want, not avoiding the life you fear. |
Run, You Clever Boy! [9085]
Re: Random walks and "on sale" stocks - confused
You keep flipping, and I'll keep adjusting my prediction.TheTimeLord wrote:You are correct and yet the most unlikely of events is a strict alternating of flips throughout the rest of the test meaning your expectations will constantly be readjusted to other predictions.jhfenton wrote:Actually, if I assume that the coin is a fair coin despite the run of 6 heads, I assume that after 1,000 flips, I should now expect 503 heads and 497 tails. There is no reason to expect reversion to the mean if each is an independent trial.TheTimeLord wrote:Are you sure? Let's say you are going to flip a coin 1,000 times and the first 6 flips are heads do yourbaldini wrote: Similarly, you would not predict a coin to flip heads after a run of 5 tails.
A) Think this is a statistically meaningfully event that has now had an affect on the outcome of the 1,000 flips and I should adjust my prediction of the results accordingly
B) Think this is part of the random nature of flipping a coin and it is likely it will even out over the 1,000 flips
If you think B then you are assigning a slight statistical advantage to tails based on the previous 6 flips.
Is there anything less likely in a 1,000 coin flips than one exact given order for example alternating heads and tails throughout the entire 1,000 flips?
Market returns, though, are not independent trials. In the short term, there is serial correlation (momentum) with an element of randomness; in the long-term, valuations matter.
As Benjamin Graham put it, “In the short run, the market is a voting machine but in the long run, it is a weighing machine.”
Re: Random walks and "on sale" stocks - confused
If you are saying "given that you know the market will rise to some fixed value later, it's better to buy at the bottom of the market," then obviously I agree with you, and you don't need to spell that principle out in six steps for me to understand it.Try this experiment:
1) Go to M*, type in VTSAX, then click on the "Chart" tab. (You can delete the two default indexes that are automatically populated on the chart for comparison by hovering over their names and clicking the "x" boxes — keep it simple and isolate the total stock market index fund.)
2) If the chart doesn't start with it by default, click on the 10 year ("10Y") zoom option, and marvel at the volatility.
3) Go to the start date box (it will be showing "01/09/2006"), and edit it to: "09/12/2008" and use the "Tab" key on your keyboard to activate your entry.
4) Note the "growth" value: $18,184.82. That's how much a $10,000 investment on the starting date would be worth on the ending date (yesterday). That represents an 81.84% total return in a little over 8 years.
5) Now edit the start date box to one month later: "10/12/2008."
6) Note the "growth" value: $25,301.13. That's how much a $10,000 investment on the starting date would be worth on the ending date (yesterday). That represents an 153.01% total return in a little over 8 years.
So the question is, which date was better for entry into the market?
But that is different from saying "you should buy when the market has dropped recently."
In a random exponential walk, the expected value at time t is x*(1+r)^t, where x is the value at time 0 and r is the growth rate. The return is found by dividing by the amount I paid: x*(1+r)^t/x = (1+r)^t.
If next month the price drops to x(1-d) and I buy then, then under a random walk the expected value at time t is (x-d)*(1+r)^t. The return on investment is found by dividing by the original cost: (x-d)*(1+r)^t/(x-d) = (1+r)^t. That is, exactly the same return.
The reason it's the same is because it's a random walk: exponential growth starts from the current point, not from last month's point. It doesn't make up for lost money. The model you seem to have in mind is that after the drop to value (x-d), the fund will grow back to the value it would have grown to, prior to the drop. AKA compensatory growth. AKA predicting tails after a run of heads.
My question is: does the market work this way?
Re: Random walks and "on sale" stocks - confused
It seems to me that an upward bias of some sort is a minimum precondition for rational investors. But if owning stocks has a positive expected return, then it follows that owning more stocks (of the same type) should have a larger expected return, in absolute money. This makes being able to buy more shares for the same money a good thing.lack_ey wrote:A random walk that's generalized to be upward biased in some way, obviously (or just a random walk on top of an upward moving process, whatever you prefer). Is that what you're talking about or were you thinking about the case where the expected return is zero?telemark wrote:I don't think the market follows a random walk, although modeling it as one is an interesting exercise that can yield some useful insights. If the market truly were random, why would anyone invest in it? Why not just go to Las Vegas where the shows are better?
(In other words, I don't think a process with an upward bias qualifies as random.)
Re: Random walks and "on sale" stocks - confused
I'm not saying either one of the two statements above. This comes closer:rbaldini wrote:If you are saying "given that you know the market will rise to some fixed value later, it's better to buy at the bottom of the market," then obviously I agree with you, and you don't need to spell that principle out in six steps for me to understand it.Try this experiment:
1) Go to M*, type in VTSAX, then click on the "Chart" tab. (You can delete the two default indexes that are automatically populated on the chart for comparison by hovering over their names and clicking the "x" boxes — keep it simple and isolate the total stock market index fund.)
2) If the chart doesn't start with it by default, click on the 10 year ("10Y") zoom option, and marvel at the volatility.
3) Go to the start date box (it will be showing "01/09/2006"), and edit it to: "09/12/2008" and use the "Tab" key on your keyboard to activate your entry.
4) Note the "growth" value: $18,184.82. That's how much a $10,000 investment on the starting date would be worth on the ending date (yesterday). That represents an 81.84% total return in a little over 8 years.
5) Now edit the start date box to one month later: "10/12/2008."
6) Note the "growth" value: $25,301.13. That's how much a $10,000 investment on the starting date would be worth on the ending date (yesterday). That represents an 153.01% total return in a little over 8 years.
So the question is, which date was better for entry into the market?
But that is different from saying "you should buy when the market has dropped recently."
Do you disagree?Speaking in very general terms (and, again, about broad market index funds), no matter where the market ends up on any given future date, your returns will be better on the shares you buy after a market drop large enough to cause widespread concern than on the shares you bought soon before such a drop.
"Discipline matters more than allocation.” |—| "In finance, if you’re certain of anything, you’re out of your mind." ─William Bernstein
Re: Random walks and "on sale" stocks - confused
My question can really be boiled down to this.bonn wrote: Return varies with time and that doesn't by itself violate the EMH, as far as I know. The period after a crash is/can be a period of higher return. Unless you think you can predict crashes better than the market itself can, I don't see how that violates the EMH? It seems to me like saying that if interest rate increases cause bond returns to increase, then that violates the EMH. Maybe I'm not understanding the argument here?
Let's say you believe the annual expected return on an investment is 5%, if you buy now.
Now suppose the value drops by 50%. Do you believe the annual expected return is now greater than 5%?
Under my view of an exponential random walk, the answer is "no:" the expected return in the future is just the same as it is now. Again, we predict 50% heads in the future, regardless of a recent history. As lack_ey said, I'm basically imagining a world where, every day, a randomly generated factor multiplies the value of your investment. The factor is independent of recent history.
Is this an unrealistic model of the market?
Re: Random walks and "on sale" stocks - confused
No, I don't disagree.iceport wrote: Speaking in very general terms (and, again, about broad market index funds), no matter where the market ends up on any given future date, your returns will be better on the shares you buy after a market drop large enough to cause widespread concern than on the shares you bought soon before such a drop.
Do you disagree?
But my point is this: under a random walk model, if the value drops by factor (1-d) in the short term, then its expected value in the future has also dropped by that same factor. So the clause "no matter where the market ends up on any given future date" is misleading. You should not expect it to end up at the same place before and after a drop, if you're following a random walk. Hence, no more reason to buy after a drop than before.
Re: Random walks and "on sale" stocks - confused
A zero-mean random variable is not the only kind of random variable. "Random" in the usual sense does not necessarily imply zero mean. If we flip fair coins and you get $1 on heads and lose $0.50 on tails then the outcome is random—non-deterministic—and can be modeled over time as a kind of random walk but this is not zero mean. You could also analyze this as earning $0.25 on every flip +/- $0.75 based on the outcome, where the +/- $0.75 is the random walk. That kind of adjustment is trivial.telemark wrote:It seems to me that an upward bias of some sort is a minimum precondition for rational investors. But if owning stocks has a positive expected return, then it follows that owning more stocks (of the same type) should have a larger expected return, in absolute money. This makes being able to buy more shares for the same money a good thing.lack_ey wrote:A random walk that's generalized to be upward biased in some way, obviously (or just a random walk on top of an upward moving process, whatever you prefer). Is that what you're talking about or were you thinking about the case where the expected return is zero?telemark wrote:I don't think the market follows a random walk, although modeling it as one is an interesting exercise that can yield some useful insights. If the market truly were random, why would anyone invest in it? Why not just go to Las Vegas where the shows are better?
(In other words, I don't think a process with an upward bias qualifies as random.)
You can read a number of papers on it, for example this:rbaldini wrote:My question is: does the market work this way?
http://papers.ssrn.com/sol3/papers.cfm? ... id=1947305
It's not a completely answered question in academia, and there's a lot more out there.
Let's suppose the expected 5% comes from a 2% current dividend yield and about a 3% expected price increase.rbaldini wrote:My question can really be boiled down to this.bonn wrote: Return varies with time and that doesn't by itself violate the EMH, as far as I know. The period after a crash is/can be a period of higher return. Unless you think you can predict crashes better than the market itself can, I don't see how that violates the EMH? It seems to me like saying that if interest rate increases cause bond returns to increase, then that violates the EMH. Maybe I'm not understanding the argument here?
Let's say you believe the annual expected return on an investment is 5%, if you buy now.
Now suppose the value drops by 50%. Do you believe the annual expected return is now greater than 5%?
Under my view of an exponential random walk, the answer is "no:" the expected return in the future is just the same as it is now. Again, we predict 50% heads in the future, regardless of a recent history. As lack_ey said, I'm basically imagining a world where, every day, a randomly generated factor multiplies the value of your investment. The factor is independent of recent history.
Is this an unrealistic model of the market?
If the price drops in half with none of the fundamentals changed, even if you assume a 3% expected price increase as before, the current dividend yield is now 4%...
Of course, nothing happens in a vacuum and for no reason. In practice the price drops in half perhaps because the expected dividend yield in the future is lower or expected price increases are lower or whatever else.
Last edited by lack_ey on Sat Jan 09, 2016 12:37 pm, edited 2 times in total.
- Maynard F. Speer
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Re: Random walks and "on sale" stocks - confused
If it's a random walk we're all just seeing faces in clouds
I think Robert Shiller claims the market's better described as an AR-1 Autoregressive model
Which is essentially a random walk in the short-term (simulating the coin tosses of news and global developments) but with a mean-reverting tendency (which is what you look to valuations for)
I think Robert Shiller claims the market's better described as an AR-1 Autoregressive model
Which is essentially a random walk in the short-term (simulating the coin tosses of news and global developments) but with a mean-reverting tendency (which is what you look to valuations for)
"Economics is a method rather than a doctrine, an apparatus of the mind, a technique of thinking, which helps its possessor to draw correct conclusions." - John Maynard Keynes
Re: Random walks and "on sale" stocks - confused
Yes. I believe the expect return is much higher after a 50% drop than it was before. Valuations matter in the long run. Short-run fluctuations look random, but long-term trends and valuations are not random.rbaldini wrote:My question can really be boiled down to this.bonn wrote: Return varies with time and that doesn't by itself violate the EMH, as far as I know. The period after a crash is/can be a period of higher return. Unless you think you can predict crashes better than the market itself can, I don't see how that violates the EMH? It seems to me like saying that if interest rate increases cause bond returns to increase, then that violates the EMH. Maybe I'm not understanding the argument here?
Let's say you believe the annual expected return on an investment is 5%, if you buy now.
Now suppose the value drops by 50%. Do you believe the annual expected return is now greater than 5%?
Under my view of an exponential random walk, the answer is "no:" the expected return in the future is just the same as it is now. Again, we predict 50% heads in the future, regardless of a recent history. As lack_ey said, I'm basically imagining a world where, every day, a randomly generated factor multiplies the value of your investment. The factor is independent of recent history.
Is this an unrealistic model of the market?
Forget the exponential random walk model. No one believes that describes the equities market.
Re: Random walks and "on sale" stocks - confused
+1Maynard F. Speer wrote:Which is essentially a random walk in the short-term (simulating the coin tosses of news and global developments) but with a mean-reverting tendency (which is what you look to valuations for)
- nisiprius
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Re: Random walks and "on sale" stocks - confused
No, he didn't. Warren Buffett said it was a weighing machine in the long run and attributed that to Graham. However, nobody has been able to find any evidence, beyond Warren Buffett's memory, in any of Graham's published writing, and Jason Zweig, editor and annotator of the most recent edition of The Intelligent Investor, tried and failed. Graham did not say it was a weighing machine in the long run. All Graham said is that it wasn't a weighing machine in the short run. An accurate quotation is:jhfenton wrote:As Benjamin Graham put it, “In the short run, the market is a voting machine but in the long run, it is a weighing machine.”
In other words, the market is not a weighing machine, in which the value of each issue is registered by an exact and impersonal mechanism, in accordance with its specific qualities. Rather we should say that the market is a voting machine, whereon countless individuals register choices which are partly the product of reason and partly the product of emotion.
Last edited by nisiprius on Sat Jan 09, 2016 12:44 pm, edited 2 times in total.
Annual income twenty pounds, annual expenditure nineteen nineteen and six, result happiness; Annual income twenty pounds, annual expenditure twenty pounds ought and six, result misery.
Re: Random walks and "on sale" stocks - confused
One of the lessons I learned back when I was picking my own stocks [unsuccessfully], is that before one determines why the market price is wrong, one should understand what the market is saying with it's price and why it most likely is right.
It simply isn't true that a stock selling at 10x earnings is priced wrong vs. one selling at 20x and therefore "is expected" to make you rich. Should Cooper Tire be selling at a significantly lower multiple than Amazon? I think so. How much is of course a matter of debate.
It simply isn't true that that market was guaranteed to recover the way it did since 2009. For example, the bank bailouts did rescue common shareholders in the banks (like us). The government could have instead taken them all through some type of bankruptcy process, meaning that shareholders would have been wiped out and we could have instead bought back in several years later when new stock was issued. Stock market gains since 2009 would have been significantly lower had this route been taken. The market multiple was low in Jan-2009 because there were good odds that large segments of the market were going to zero.
The things that make us rich or poor are generally the things we don't expect. A good exercise is to go back and read the old "Death of Equities" article from Business Week back in the late 70s. People like us like to chortle about how dumb the article was. It isn't. The market did so well because the country solved the problems that article identified back then (inflation, productivity, taxes). That wasn't expected.
My point is not that the market is always right (I'm less of an EMH guy than most here, I think). It's just a good idea to understand the other guy's (the market in this case) position before you explain to him why he is wrong. Hopefully that's not just a good lesson for investing...
It simply isn't true that a stock selling at 10x earnings is priced wrong vs. one selling at 20x and therefore "is expected" to make you rich. Should Cooper Tire be selling at a significantly lower multiple than Amazon? I think so. How much is of course a matter of debate.
It simply isn't true that that market was guaranteed to recover the way it did since 2009. For example, the bank bailouts did rescue common shareholders in the banks (like us). The government could have instead taken them all through some type of bankruptcy process, meaning that shareholders would have been wiped out and we could have instead bought back in several years later when new stock was issued. Stock market gains since 2009 would have been significantly lower had this route been taken. The market multiple was low in Jan-2009 because there were good odds that large segments of the market were going to zero.
The things that make us rich or poor are generally the things we don't expect. A good exercise is to go back and read the old "Death of Equities" article from Business Week back in the late 70s. People like us like to chortle about how dumb the article was. It isn't. The market did so well because the country solved the problems that article identified back then (inflation, productivity, taxes). That wasn't expected.
My point is not that the market is always right (I'm less of an EMH guy than most here, I think). It's just a good idea to understand the other guy's (the market in this case) position before you explain to him why he is wrong. Hopefully that's not just a good lesson for investing...
Re: Random walks and "on sale" stocks - confused
Thanks. I did a quick web search, found the quote with which I was familiar, and quoted it.nisiprius wrote:No, he didn't. Warren Buffett said it was a weighing machine in the long run and attributed that to Graham. However, nobody has been able to find any evidence, beyond Warren Buffett's memory, in any of Graham's published writing, and Jason Zweig, editor and annotator of the most recent edition of The Intelligent Investor, tried and failed. Graham did not say it was a weighing machine in the long run. All Graham said is that it wasn't a weighing machine in the short run. An accurate quotation is:jhfenton wrote:As Benjamin Graham put it, “In the short run, the market is a voting machine but in the long run, it is a weighing machine.”In other words, the market is not a weighing machine, in which the value of each issue is registered by an exact and impersonal mechanism, in accordance with its specific qualities. Rather we should say that the market is a voting machine, whereon countless individuals register choices which are partly the product of reason and partly the product of emotion.
I still like the quote.
Re: Random walks and "on sale" stocks - confused
rbaldini,rbaldini wrote:No, I don't disagree.iceport wrote: Speaking in very general terms (and, again, about broad market index funds), no matter where the market ends up on any given future date, your returns will be better on the shares you buy after a market drop large enough to cause widespread concern than on the shares you bought soon before such a drop.
Do you disagree?
But my point is this: under a random walk model, if the value drops by factor (1-d) in the short term, then its expected value in the future has also dropped by that same factor. So the clause "no matter where the market ends up on any given future date" is misleading. You should not expect it to end up at the same place before and after a drop, if you're following a random walk. Hence, no more reason to buy after a drop than before.
I'm not an economics professor or professional, just a small investor. But for a broad market index, I don't think your assumption is correct. The expected return *most certainly does* increase when valuations decrease, all else equal.
An actual professional, Larry Swedroe, has provided his insights up-thread: viewtopic.php?p=2751381#p2751381
"Discipline matters more than allocation.” |—| "In finance, if you’re certain of anything, you’re out of your mind." ─William Bernstein
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Re: Random walks and "on sale" stocks - confused
The "stocks on sale" metaphor gripes me because it is an obfuscation of situations that are clearly different.
In a retail store, an item that is "on sale" is verifiably the same article that it was when it was selling at a higher price. It may be on sale because nobody liked the color, or it may be a loss leader, but it is the same thing as it was before the sale.
A stock's price drops because investors believe it is not the same thing as it was before. The future prospects for the company have gotten worse... perhaps because it was caught cheating on emissions tests, or perhaps its customers were getting food poisoning, or perhaps just because the global economic outlook looks worse.
The proper comparison is not with an item that's "on sale," but an item whose price has been reduced because it's out of box, or has gotten scratched, or is close to its sell-by date. If you are in the grocery store and there is a package of hamburger for $12, and next to it is one with tomorrow's sell-by date and a label saying "$3 off manager's special," it not automatic that you should buy that one. A sane person could have many reasons to prefer the other.
Just because something has had its price reduced does not automatically make it a bargain. It might be, or it might not. And the judgement process is basically the same--the fact that the price was reduced doesn't really tell you whether it was reduced by not enough, just the right amount, or more than it needed to be.
In a retail store, an item that is "on sale" is verifiably the same article that it was when it was selling at a higher price. It may be on sale because nobody liked the color, or it may be a loss leader, but it is the same thing as it was before the sale.
A stock's price drops because investors believe it is not the same thing as it was before. The future prospects for the company have gotten worse... perhaps because it was caught cheating on emissions tests, or perhaps its customers were getting food poisoning, or perhaps just because the global economic outlook looks worse.
The proper comparison is not with an item that's "on sale," but an item whose price has been reduced because it's out of box, or has gotten scratched, or is close to its sell-by date. If you are in the grocery store and there is a package of hamburger for $12, and next to it is one with tomorrow's sell-by date and a label saying "$3 off manager's special," it not automatic that you should buy that one. A sane person could have many reasons to prefer the other.
Just because something has had its price reduced does not automatically make it a bargain. It might be, or it might not. And the judgement process is basically the same--the fact that the price was reduced doesn't really tell you whether it was reduced by not enough, just the right amount, or more than it needed to be.
Last edited by nisiprius on Sat Jan 09, 2016 12:50 pm, edited 1 time in total.
Annual income twenty pounds, annual expenditure nineteen nineteen and six, result happiness; Annual income twenty pounds, annual expenditure twenty pounds ought and six, result misery.
Re: Random walks and "on sale" stocks - confused
Okay, regarding Larry's post
The modelers I know (and I) call this a "random walk with drift." The expected growth rate is fixed, but there is noise each time you sample it. This is exactly the model I have in mind.larryswedroe wrote:Here's way to think about it
First, market doesn't move randomly, it moves randomly with up bias.
Here's the essential question: does the upward bias increase after a drop? I've assumed no, but apparently others who know more about the actual economy disagree.larryswedroe wrote:Second, when market falls it then moves randomly from there, with an upward bias.
Is there any prescription for knowing that a drop is the result of falling valuations, but not earnings? Nisiprius mentions just above that it may not be so clear.larryswedroe wrote: Third, valuations do matter, so if market falls and it's because valuations have fallen (not earnings falling) then you have higher earnings yield and thus higher expected returns from then on.
If there is short term momemtum, then poor returns now mean poor returns in the near future, in which case buying after a drop would be a bad thing (although that's short-term investing).larryswedroe wrote: One last thing, markets do not move purely randomly as short term momentum is well documented.
Re: Random walks and "on sale" stocks - confused
But nisiprius, aren't you conflating an individual company with the broad market represented by thousands of companies? The total us stock market index dropped what, about 6% last week? Is it realistic to assume that something went wrong with over 3,700 individual companies all at once? As long as we confine ourselves to broad markets, it seems like a 6% drop in a week is something of a sale to me...nisiprius wrote:The "stocks on sale" metaphor gripes me because it is an obfuscation of situations that are clearly different.
In a retail store, an item that is "on sale" is verifiably the same article that it was when it was selling at a higher price. It may be on sale because nobody liked the color, or it may be a loss leader, but it is the same thing as it was before the sale.
A stock's price drops because investors believe it is not the same thing as it was before. The future prospects for the company have gotten worse... perhaps because it was caught cheating on emissions tests, or perhaps its customers were getting food poisoning, or perhaps just because the global economic outlook looks worse.
The proper comparison is not with an item that's "on sale," but an item whose price has been reduced because it's out of box, or has gotten scratched, or is close to its sell-by date. If you are in the grocery store and there is a package of hamburger for $12, and next to it is one with tomorrow's sell-by date and a label saying "$3 off manager's special," it not automatic that you should buy that one. A sane person could have many reasons to prefer the other.
Just because something has had its price reduced does not automatically make it a bargain. It might be, or it might not. And the judgement process is basically the same--the fact that the price was reduced doesn't really tell you whether it was reduced by not enough, just the right amount, or more than it needed to be.
"Discipline matters more than allocation.” |—| "In finance, if you’re certain of anything, you’re out of your mind." ─William Bernstein