If you do not thoroughly understand the evidence for and against the Efficient Market Hypothesis, Modern Portfolio Theory, volatility as a measure of risk and beta, you will not be armed to resist the absolutely pervasive and seductive role of these ideas in the investment industry today. And believe me, they creep in everywhere.
Current and recent prices influence subsequent prices. This is not to say that prices are determined in some fashion by previous prices. It’s just that an influence exists. It is difficult to predict future prices by what has gone before. But, it can’t be said the data series of prices is independent. No doubt prices bounce around fair value, but the bouncing is not ‘random’ in the statistics sense.
The supporters of the EMH say that if you make a graph plotting a series of price variation data is will display a shape that closely resembles a bell curve. They say the bell curve looks like one you would get if you plotted data from flipping coins. But, ‘closely’ doesn’t make it so.
If you plot all the monthly movements of the Dow Jones index on a chart, there is much less clustering around the average, and there are many more big rises and falls out at the extremes, which the statisticians call ‘fat tails’.
From this look at the relationship between past prices and current and future prices and the shape of the distribution of stock prices there seems to be good reason to doubt these underpinnings of the EMH.
Malkiel seems to have retreated significantly in the ninth edition of the famous A Random Walk Down Wall Street.
With all due respect for academic proponents of efficient markets, in my experience markets are continuously foolish, thanks to investors who, despite George Santayana’s famous admonition, forget the past.
It is not useful, which is probably the most hurtful thing you can say about a stock market model.
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