Financial Theory: Undoing the Mistakes

Investors fail to grasp the root of today’s volatility, incapable of determining a better strategy than the rote, myopic style they learned in years past.

I have heard it said, “We spend our entire childhood being taught the way to do things, and the rest of our lives trying to undo all that we learned.” This is particularly accurate in portfolios — investors failing to grasp the root of today’s volatility, incapable of determining a better strategy than the rote, myopic style they learned in years past. Many behaviors which prevail during portfolio construction are unfortunately grounded in faulty lessons from our “youth” — we incessantly create performance pain through approaches that are improperly deemed reasonable. However, with honest effort and a little guidance it is possible to purposefully unwind the many mistakes of our earlier portfolio management — replacing current habits with a healthy dose of financial theory.

To gain a full grasp and properly frame the issues at hand, we first turn to the relationship between financial markets and randomness. Though randomness as a market theory has significantly popularized in recent years, some trace its origin to as early as 1827 with botanist Robert Brown observing and studying the spontaneous movement of pollen grains. In his research, Brown microscopically witnessed pollen grains in water and noted atomic bombardment constantly changing, sometimes affecting one side of the grain more than another (causing randomness is their motion). An easy definition comes from a typical source, “A random movement of microscopic particles suspended in liquids or gases resulting from the impact of molecules of the surrounding medium” (Merriam-Webster). From his work, the physical phenomenon known as Brownian motion has been documented and henceforth leveraged. In particular, financial models apply the Brownian movement of particles to industry attempts at confirming randomness as the driving force in global markets.

Financial theorists continue to hypothesize on the particular variety of cause and effect present in security price fluctuations, varying from fundamental analysis and the Efficient Market Hypothesis to randomness, with final opinions oftimes contentiously split. And, despite overwhelming evidence of emotions in markets (and therefore the existence of randomness), underlying fundamentals (i.e. fundamental analysis) remain the foremost form of price valuation. Analysts continually review financial statements to pontificate on the future. Balance sheets, income statements, statements of cash flows, SEC filings, P/E ratios, and much more are cited as substantiation as the majority of analysts cling to yesterday’s popular belief while ignoring today’s reality. Nonetheless, and despite their fame in the field of finance, fundamentals leave us far from seeing a complete picture of the forces at play and lack an acknowledgment of the evident random movements in security prices.

In addition to fundamentalists, there are others who refute fundamental analysis yet still fall short of finding randomness at fault for security price movement. These market participants continuously cite another theory as the main backdrop for market functionality — the Efficient Market Hypothesis (EMH). EMH claims that all available information is immediately and properly inculcated into the price of a security; the price at all times reflects every available statistic and quality of information. EMH asserts there is literally no way to outsmart markets — particularly as globalization and technology make the flow of information more constant, the velocity of information faster, and the availability of information more abundant. As such, EMH refutes all forms of analysis, including fundamental. Yet still, there is one vital component left unaccounted for: randomness. Even EMH theorists fall short of recognizing the random movements of markets, preferring to search for and find causes after-the-fact in one or many grandiose hypotheses.

To the astute observer the answer is right in front of our face — security prices indeed move randomly from moment to moment and day to day.  And, though the human brain has tremendous difficulty admitting unpredictability — we are innately built to look for patterns, even when there are none — it importantly holds that markets are influenced by not only fundamentals but emotions, rendering them truly haphazard and incapable of being projected.

In the end, analyzing markets without admitting and accounting for emotions (and therefore randomness) is asking for an eventual meltdown. Thinking markets are efficient and rational (when in fact they are inefficient and random) is setting yourself up for failure.  Not accounting for the spontaneous elastic nature of security prices is the slow form of financial suicide. In our early years of investing, we learn of many tools, concepts, and notions, including valuations, ratios, yield, and execution; we read and choose between varying creeds of theory and understanding. We must now become more mature, evolve, and embrace a simple truth that is ignored by some and feared by others. Randomness is not only apparent in financial markets, it is omnipresent. And, coming to terms with this fact is not just correct in theoretical expression, but may be the last and only chance we’ve got at succeeding in today’s world of heightened volatility and abundance of self-proclaimed market “gurus.”  Quite plainly, the market is much more random than we think or care to admit.