I first got an inkling of foolish mathematical "investing" when I sat in the Stanford auditorium at the finance course taught by Professor Bill Sharpe, who later got the Nobel Prize for his share in formulating the efficient market theory (EMT). That silly theory states that no investor can make more money than others in the market without taking on more risk, because whatever information he has is also available to all others.
All investors are presumed to be rational, and so all buy the same things, which quickly reach an equilibrium price where no one makes any money. This equilibrium price fluctuates randomly, and so is impossible to predict, EMT says. The inevitable conclusion is that the only way to make more money than others in stocks is to take on more risk by acting without enough information. If you don't want to take such a risk, you should buy the "market" via an index fund, then stay home and read a book or watch TV.
This theory (further elaborated by Bill Merton, Harry Markowitz, Eugene Fama, and others who won Nobel prizes) was described in math, and so was accepted by all business schools worldwide; and if you have an MBA or CFA, chances are you had to study it also. What I didn't know then was that EMT would soon be proven bunk, nor did I know that Warren Buffett had mocked EMT mercilessly, offering to endow chairs to teach it, so that more "investors" would sell what he buys and buy what he sells. Although I didn't know any of this, I knew math well enough (my first degree was in aeronautical engineering) to pick my way through EMT's Greek letters and see that the entire logical edifice hung on a few assumptions that were utterly and clearly foolish. Indeed, some years later, another Stanford professor (Mordecai Kurtz of the Economics Department) proved that EMT is bunkum. How?
First, EMT adherents implicitly assume that the market will behave tomorrow just as it had yesterday (in math it's called being invariate in time) -- else how could different investors with the same (past) data forecast the same (future) equilibrium prices? Prof. Kurtz showed that this assumption was dead wrong.
Second and more egregious, EMT automatically equated information with widely disseminated info -- what you read in the papers and see on the Internet -- as opposed to the raw facts these letters and numbers describe. It never crossed any professor's mind that you can sleuth out physical data for yourself, keep quiet about what you find, then use it to take the money off those too lazy to bestir themselves to do likewise.
But third and most important, EMT is simply irrelevant to stock investments -- because it is descriptive, not prescriptive.
It is as if an engineer were asked to teach you how to build a bridge, but instead of showing you how to attach beams to each other, and cross-hatch joists, he would bring you the spectral analysis of the light reflected off the bridge's surface. Sure, it would be "true," but so what? It would be entirely irrelevant to building bridges.
Similarly, the fact that stock prices vibrate randomly, although true, is irrelevant to money making. The efficient market theory really tells stories (in math, yes, but stories) about investing, rather than showing you how to buy good stocks cheaply from others.
So why am I telling you this? Because a few days ago I finished a terrific book called Fortune's Formula, about gangsters trying to break the casino with the help of math professors, mathematical hedge funds and a cast of dozens of colourful characters -- among whom is the late Claude Shannon, an MIT professor.
For the non-techies among you, Prof. Shannon is the father of information theory, and his contribution to science is often compared to that of Einstein. What I didn't know yet was that Prof. Shannon was also an enthusiastic investor, who for many years invested alongside his wife with great success. In fact, his long-term record has been better than Mr. Buffett's.
Aha! EMT adherents must be saying. If the father of info theory beat Warren Buffett, surely it's a proof that numbers alone tell the tale. No it isn't.
By his own admission, Prof. Shannon never used info theory. So how did he invest? Ah. He and his wife interviewed company managements, tested the products, talked to competitors and suppliers, then stayed invested for years. In other words -- they sleuthed companies and invested for the long term. No info science, no EMT.
Why not? Because manipulating public data indeed can't suck more info out of it than others can. So the only edge is in exclusivity -- non-numerical, human info that you get yourself. "Mr. Info Theory" himself said so.
So next time you are tempted to invest based on alpha, beta, gamma, charts or graphs -- take a break, call the company's clients, and ask about their buying intentions. It is their money, after all, that you are trying to take via the stock.
Avner Mandelman is president and chief investment officer of Giraffe Capital Corp., a Toronto-based money management firm.
© The Globe and Mail
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