The immensely skilled like Buffett, Munger, and Klarman put no faith whatever in things like the efficient market hypothesis and modern portfolio theory. They have learned these artifacts relate to the market and not to the business values they wish to concern themselves with.
The unskilled know little about the statistical approach and instead rely on hunches,gossip, and the wisdom of the television pundits.
The ones somewhere between are at risk
There is a long history of interpreting market activity using statistics. There is quite a large data set and often that actually holds truth. Market statistics are risky because they are influenced by emotions
Results are not like the familiar normal distribution. Bell curve. Market statistics are distributed very differently. Compared to the normal distribution, the curve is taller and more narrow with bumps on each end. The ends are interesting. Fear on the left and greed on the right.
Economists use well known techniques and the results are internally consistent. But there are some assumptions that matter.
The Bell curve assumes events are independent of each other. Anyone who believes the market has no memory is not paying attention.
Second risk is a proxy measurement. Variability is not really risk in the conventional sense. If variability is an asset, like it is for the elite investors, risk has little real meaning.
Economists use averaging techniques to make complex situations easier to analyze. Market equilibrium ideas are not real world. Unusual and previously unseen events occur and matter. Black Swan ideas. Equilibrium ideas are comforting but unrealistic. The stock and bond markets are more complicated than a pro basketball game and no one talks about the equilibrium condition of the Warriors versus the Cavaliers.
Business schools like the statistical approach because it is easy to teach. A professor could teach it without any practical awareness of the market itself. An engineering professor or a math professor would have little difficulty.
If you rely on information that is abstract, you will do badly when it is incomplete. Remember the idea from yesterday. The right level of generalization matters. You cannot express the stock market with a few numbers. Averaging, proxy measures, and using incomplete statistical analysis don’t work reliably. It violates Einstein maxim.
A thing should be made as simple as possible, but not simpler.
“If you are going to use probability to model a financial market, then you had better use the right kind of probability. Real markets are wild. Their price fluctuations can be hair-raising-far greater and more damaging than the mild variations of orthodox finance. That means that individual stocks and currencies are riskier than normally assumed. It means that stock portfolios are being put together incorrectly; far from managing risk, they may be magnifying it. It means that some trading strategies are misguided, and options mis-priced. Anywhere the bell-curve assumption enters the financial calculations, an error can come out.”
I wonder what he really thinks. Be very cautious.
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. email@example.com 866-285-7772