Stock Market Index Statistics May Be Meaningless

Knowledge is not forever.  Experience  relates only to a particular situation.  What was once true may be true no longer.

You will suffer if you apply old knowledge and experience to new context.  The question of the day becomes, “When designing your investment portfolio, how sure are you that volatility is risk and that diversification necessarily provides safety?”

If you look at Nobel laureates Harry Markowitz work in the early ’50s and William Sharpe’s work somewhat later, you could easily believe that portfolio design is settled science.  It may not be so simple.  The context of the data from which their results were derived is fundamentally different today.

In their time, people bought stock as an investment.  The value judgement was as simple as the present value of future dividends.  Today much of the trades are based on pricing issues rather than value issues.

That is qualitatively different.  Trading and investing are not the same thing and if the motive for purchasing changes, so does the meaning of the transaction.

High velocity trading accounts for over half the trades on the New York Stock Exchange.  These trades typically complete in less than 60 milliseconds.  When Markowitz was busy in the early ’50s, high velocity trading accounted for about zero percent, and none of it happened in 55 milliseconds.

When you take the holding time factor out of the investment equation, what do you really have left?

Some statistics are already noticeably different.  The correlation between price level and volume has become random.  Twenty-five years ago the price level and the volume were highly correlated.  (R-squared around .80)  Not so much today.  (R-squared is about .1)

With much higher volume, and the purpose of the trades being dramatically different, it is difficult to imagine that the market’s analytics mean the same thing as they once did.  If beta and the Sharp ratio are meaningless, what then?

Does anyone know what volatility and risk mean in the electronic trading world?  Not likely.  Most of the high velocity trades are not speculative.  They lock in a price anomaly and keep the difference.  No risk at all.

The market is more chaotic now but, strangely, less volatile. and reliance on old techniques applied to qualitatively different new data is a fool’s game.  This leads to two questions:

  1. Is an index that is created by trades where a 5 millisecond difference matters, (as with Project Express) the same as an index built on the activities of people who buy and sell, as investors, over a period of years?
  2. And if the market is not the same, does Modern Portfolio Theory and its derivatives still work?

Over the years, I have decided that it is not smart to play games when you don’t know the rules, who is on the opposing team, and how they keep score.  So, it could be that a common sense approach to investing will make more sense.  Pay less attention to statistical material and more to the businesses you are acquiring.

This is an evolving area of study.  You might find some books useful.  Taleb’s “The Black Swan” and “Antifragile” provide some insight.  So too does, “The (Mis)behaviour of Markets” by Benoit Mandelbrot and Richard Hudson.  The subtitle to the Mandelbrot book is a little fearsome, “A Fractal View of Financial Turbulence”  Not exactly high school math.

Using bad techniques on good data or good techniques on bad data, results in failure.  I cannot predict what happens when you use bad techniques on bad data, but I think that is where we are.

Be selective.  Find securities or funds that specifically suit your purpose.

Don Shaughnessy arranges life insurance for people who understand the value of a life insured estate. He can be reached at The Protectors Group, a large insurance, employee benefits, and investment agency in Peterborough, Ontario.  In previous careers, he has been a partner in a large international public accounting firm, CEO of a software start-up, a partner in an energy management system importer, and briefly in the restaurant business.

Please be in touch if I can help you.  don@moneyfyi.com  866-285-7772

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