# Inefficient Markets

I’ve posted this before, but since the conversation about Buffett came up, I thought I would re-post. I’m not sure why most hedge fund managers can’t beat the market – some do – but maybe it’s just because most humans can’t. But Buffett definitely believes it’s possible because he did it! Here’s the quote:

Host: You don’t subscribe to the efficient market theory? (That says basically you can’t beat the stock market.)

Buffett: Well if I believed that theory I’d still be delivering papers. No, I don’t think there’s any question that certain people who evaluate stocks as businesses can make intelligent decisions about business which will enable them to do very well in the securities market, but I don’t think somebody that is listening to a TV channel tell them what to do, or somebody jumping around with histrionics, or even some salesperson who is getting paid more money for selling them something and then getting them to change tomorrow is the key to it.

Question starts at 34:25 into this video: https://youtu.be/f4kOrk6c7T0

I for one am thankful for inefficient markets, for Saul, and for these message boards where we discuss stocks – but more importantly companies – with many of our like-minded friends who can all bring something to the table to help us all beat the market.

Bear

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I’m not sure why most hedge fund managers can’t beat the market – some do – but maybe it’s just because most humans can’t.

There is a simple answer that eludes most people, it’s the mathematics of wealth distribution!

Suppose the market had a normal distribution and everyone invested the same amount of money, half of them would beat the average and the other half would underperform.

The market does not have a normal (bell curve) distribution, it has a power law distribution. Think about a poker game with three participants each one starting with \$100. If two lose \$50 the winner makes \$100. Losers can only lose 100%, in our three player game the winner could make 200% while the other two would lose 100%. This is the mechanism behind the 80/20 Pareto rule or Pareto distribution. It has nothing to do with skill but with the mechanics of the market.

That does not mean that winners and losers are picked at random, good players will rise to the top. But the distribution will be a Pareto distribution.

I’ve created a ten player spreadsheet, they win or lose based on random numbers. It shows how the game plays out. If the bets are small they can play for a very long time (Kelly rule) but if the bets are high the losers get thrown out quickly. Check it out:

Denny Schlesinger

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What I’m saying is that if you created a market with 100 Sauls, 20 Sauls would outperform and the other 80 Sauls would underperform that market.

Denny Schlesinger

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What I’m saying is that if you created a market with 100 Sauls, 20 Sauls would outperform and the other 80 Sauls would underperform that market.

If Saul knows this, why wouldn’t he just index and be done with it?

Not Saul of course but with his strategy he “tries on” stocks and constantly rotates out of what might be the 80 to add to the 20.

Rob

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If Saul knows this, why wouldn’t he just index and be done with it?

Because he wants to try for the top 20%.

Denny Schlesinger

If Saul knows this, why wouldn’t he just index and be done with it?

Based on his track record since 1989, Saul is one of those 20 Sauls that beats the market…and probably one of the top 2 or 3 of those 20.

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Saul’s ability or instincts to get out of a stock as in LGIH at the TOP end of the range and not look back is something I need learn and improve upon.

They also say patience is a virtue. AYX for example, a few here were questioning him, why it hadn’t moved a few months ago at around 27,in relation to others and in fact dropped a few points…

Lessons learnt here… hope I take it in. Beginning to think so. Again Saul and to many on this board, many thanks to your unselfish hours of research and knowledge.

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Based on his track record since 1989, Saul is one of those 20 Sauls that beats the market…and probably one of the top 2 or 3 of those 20.

This is probably the lesson here. That it’s important to compare your returns to some benchmark (e.g. S&P 500).

How many investors think they’re outperforming but have no clue what their returns are? Because if you’re not beating the market, why are you picking stocks?

Like (seemingly) most here, I’ve done well over the past 10 years.

But there’s always this nagging thought in the back of my mind, that even the best stock pickers in the world always revert to the mean.

I don’t know how to shake that, only to keep comparing my long-term returns to the S&P 500.

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What I’m saying is that if you created a market with 100 Sauls, 20 Sauls would outperform and the other 80 Sauls would underperform that market.

Statistics like these, while I’m sure accurate, are always entertaining.

For instance, there’s the Monty Hall problem: “Behind one door is a car; behind the other two are goats. You pick a door, say No. 1, and the host, who knows what’s behind the doors, opens another door, say No. 3, which has a goat. He then says to you, “Do you want to pick door No. 2?” Is it to your advantage to switch your choice?”

Most people would say no - there are two doors and so you have a 50-50 chance. But the math says that you actually still only have the 33.3% chance you started with, and the only way to get the 50% chance is to switch.

Makes no physical sense to me, but then so is having 80% of the Sauls underperforming a market of Sauls.

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Makes no physical sense to me, but then so is having 80% of the Sauls underperforming a market of Sauls.

I’m convinced that 99% of investors, including professionals, don’t know and don’t understand the anatomy of the market, its systemic nature. You don’t need to to beat the market. When you see a headline that says that 75% of mutual funds underperform the market the implication is that they don’t know what they are doing when in reality that is the result of the systemic nature of wealth distribution. This in no way contradicts the fact that better stock pickers and better traders drift up while less talented ones drift down. But the 80/20 rule will always hold give or take, it could be 75/25 but never the 50/50 you expect from normal distributions.

I started work on a “Market Game” php web-app that does the same as the spreadsheets I posted. I’ve done most of the guts of it but the hard part is the pretty display. Did anyone try the spreadsheets?

Denny Schlesinger

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The montey hall problem you get 67% when you switch. You can prove it to yourself with 3 scenarios. But that’s just showing how easy numbers confuse most people.

Do you need any help with the coding/testing of the app?

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The montey hall problem you get 67% when you switch. You can prove it to yourself with 3 scenarios. But that’s just showing how easy numbers confuse most people.

doh on me! Guess Barbie was right: https://20prospect.files.wordpress.com/2011/07/barbie-hates-…

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I did not. Send me a notr off line.

Thanks Qazulight

Do you need any help with the coding/testing of the app?

Not yet, thanks!

Denny Schlesinger

I did not. Send me a notr off line.

Why Does the Average Mutual Fund Underperform?

It has often been stated that the average mutual fund underperforms the market but I have never seen an adequate explanation. I used to believe in a simplistic reason: Since mutual funds make up the average, if you deduct their management fees, their results will be that amount below the average. While this holds true, it is not the real reason. For an explanation we have to look at the Pareto Distribution of wealth.

https://softwaretimes.com/files/why+does+the+average+mutua.h…

Denny Schlesinger

Buffett has also said that if he could start over with \$1m, he could smash the indices and that he would
have very concentrated holdings.

Of course if he really wanted to stay under the radar, methinks he would spend less time on CNBC with
the talking hatracks.

btw, on the BRK board, consensus is running 100% that this was the worst letter to shareholders ever, and
had not one piece of new information.

http://discussion.fool.com/Message.aspx?mid=32995353&sort=wh…

Dan

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