Wide Ranging Expected Value, A Binary: LEAPS vs. Common Stock
Loan originators are either worth (a) nothing if banks continue to refuse financing loans, alternative methods of lending are not used, etc. or (b) far more than current market capitalizations if conditions reverse. If the probability of each scenario is 50%, originators have positive expected value. And under these assumptions, LEAPS are more attractive than common stock. Take the following as an illustration:
First Marblehead is currently selling at $360 million, or $3.60 per share. If banks regain the willingness to finance student loans, a conservative valuation for FMD might be $2 billion, or $20 per share. (The company earned $159 million in 2005, and conditions in 2009 might resemble those in 2005.) A person who buys 100 shares at $3.60 stands to lose $360 or to gain about 4.5 times this amount.
A LEAPS holder is much better situated. The ask price on calls expiring January 2009, strike price $10, is 70 cents. This means that one contract purchased for $70 (70 cents X 100) gives you the right to purchase 100 shares of FMD at $10 per share. If FMD goes to $20 per share by January 2009, your option contract will be worth $1,000 (($20 – $10) X 100 shares). Subtracting the $70 initially paid leaves $930, or more than 13 times your investment.
Obviously it is better to potentially gain 13 times your principal as a LEAPS holder than 4.5 times your principal as a shareholder. On the downside, it is also better to be a LEAPS holder, since only $70 is at risk as opposed to $360. If an option holder puts a comparable amount at risk, by buying 5 contracts (500 X $.70 = $350), his potential absolute dollar gain would be about 3 times greater than the shareholder’s. This distorts expected value in favor of LEAPS.
I am not advising anyone to purchase FMD LEAPS. My point is to show that they are, in this case, superior to common shares. The assumptions in the first paragraph are subject to question of course.
Ypu are oversimplifying. In January 2009 if the common sells for $9.90 per share, then your 100 shares are worth $990. The LEAPs will be worth nothing.
Thanks for the comment. I appreciate it when other people sort of test my logic.
The most rational way to deal with this problem is to simply increase the probability of loss on the options in any expected value computation. If we change the probability of loss to .75, an option holder pays $70 to get an expected value of $180. By comparison, a shareholder pays $360 to get an expected value of about $640. (.5)(2,000 – 360) – (.5 X 360) = 640.
Timing and magnitude of FMD’s price increase is an important issue. I think that by January 2009 we will probably know whether the stock is worthless. If not, it should be selling at going concern prices… most likely above $10. Tom Brown knows the business better than I do, and he thinks it’s worth more than $30 per share. There is a very low probability that FMD will sell at some intermediate price.
Finally there is the matter of how much principal you are willing to potentially lose. A $70 loss on one contract wouldn’t be noticeable. However a $360 loss on shares might be. (It’s the difference between a pair of jeans and a PlayStation 3.)
By the way, the current quote on January 2009 calls at $10 strike is 65 cents, and lower strike prices are available.
Thanks for the interesting web site and in particular, this post. In positing your argument as you did — purchase of FMD LEAPS versus FMD equity — you trade the basic advantage of an informed purchase of FMD equity [where the "what" side of the argument (i.e., "what" will happen to the company's free cash flow) is subordinated to the ticking time bomb of "when" it must happen] for a hoped for guess on time. Like a horse that can count to 10 may be a wonderful horse, it is still a poor mathematician. Also, in this same vein, a management team of a textile business may be wonderfully skillful in allocating assets within its company, but in the end its company is still, at the end of every day, in the textile business — a low-return, commmodity business. In conclusion, your proposed investment in options versus equities, while theoretically fanciful and financial fattening, is on a macro basis a dubious investment philosophy if not well suited to the individual investor’s financial status, temperament, and intellectual leanings. But, this is not to say some will profit handsomely from option trades like the one suggested. But we are all well served to fully remember and understand the importance of not practicing an investment based more on hope than informed guesses (that put our funds at great risk of permanent capital loss).
Buffett quotes are not applicable to all investment situations. Some of his fans make big mistakes by applying valid ideas in one instance to dissimmilar instances.
My argument is that FMD equity is a “ticking time bomb,” because if there are no securitizations, alternative methods of financing or capital infusions by January 2009, the company will probably be worthless. If you accept my premises of a 50/50 chance of FMD being worth $0 or $20, there is no way you can argue that common stock is preferable to options. Going from premises to conclusion is a matter of expected value. Setting up the premises is a matter of subjective probability, valuation, understanding the situation, etc. Only this can be doubted.
I was inspired to write this post after reading page 637 of Security Analysis (2nd Edition), where Ben Graham makes a similar argument. Neither he nor I have stated that stock options are categorically preferable to common stock (as you seem to have implied with the horse quote). We simply believe there is a relative advantage, when the equity has a possibility of going to $0, of putting very little capital at risk via options. If you take on the same potential grief, you might as well get the gravy.
By the way, there is a big difference between abiding slavishly to everything Buffett has written and being as brilliant as he is. Buffett’s advantage over virtually everyone is that he has a flexible, innovative mind—the result of mental integrity. My view is that Buffett fanatics tend not to have this integrity. One of my favorite Buffett quotes goes something like:
“If I say something, the world will accept it. Charlie’s advantage is that he won’t.”
I have never heard Buffett make a mistake in reasoning. Rather I believe the mistakes are made by people who apply his thoughts inappropriately. (You may be interested to know he and Joel Greenblatt used options when they were managing smaller amounts of money.)
A bit defensive Cog? While I appreciate your reply, I think your reasoning is still WAY off on your proposed investment. Why? Because you’ve missed the obvious: get the qualitative issue correct before the quantitative issue. You dumbly patch together some numbers from specious reasoning (no doubt supported by reasoning devoid of unbiased thought) and forgot to think, “Gee, I wonder how much money I could permanently lose here?” If you’re fine with a trade where the outlay is small but the reward much larger and you can possibly lose ALL your intial investment capital, that’s fine. I have NO problem at all with you doing this. I just think it’s stupid. But I respect your reasoning as your own and wish you well. And your reply from your words beginning with “By the way, …” are apt but hopelessly and wrongfully applied in my case. And as for you never hearing Buffett make a mistake in reasoning, I think you would learn something about this if you took your words to heart.
First, could you please clarify whether you are opposed to (1) taking any position in FMD (either options or stock) or (2) taking only an options position. In my opinion, any FMD position entails a higher than average probability of permanent capital loss. The common shareholders—especially those who purchased shares above $20 in the midst of securitization problems—failed to ask themselves, “Gee, I wonder how much money I could permanently lose here?” Clearly my argument is that the options are preferable for someone who really wants to bet; I have chosen not to.
Secondly, I would like you to identify precisely which assumptions are specious. I get the impression that you do not believe in forming subjective probabilities. But as Keynes argues in his Treatise on Probability, in any field where reasoning is necessary, a study of probability is necessary.
Certainly Buffett has made many mistakes, but whether they were mistakes of reasoning is a different matter. If you have a flush in poker, the rational action is to bet heavily. If it turns out that another player has a royal flush, your huge bet was not a mistake of reasoning.
Thanks for responding; opposing opinions are welcome. My only concern is the application of quotes to possibly dissimilar situations. Have a good day.
Cog, thanks for the reasoned response–it may be a big time waste but I enjoy the discussion so far. But, please think a bit more on your elementary thoughts per subjective probabilities (scattershooting here … but aren’t all probabilities subjective by their very nature and definition … until they become objective fact?). Anyway, of course, I use, enjoy, etc. probabilities. But, what good is it to use time trying to figure and write about the probabilities re. FMD’s success. No credible argument can be made for an “investment” in FMD at this time on a outside passive minority basis. Now, if one would like to specualte in FMD … be my guest. So, the answer to your first question is “both”: I wouldn’t invest in FMD’s equity or purchase options for the right to buy equity in FMD. But, yes, clearly (on a “duh” basis) options on FMD could be a superior investment if this and that and that and this come to pass, other wise … buy the equity. Can’t you see the absurdity of my last sentence? Thanks for letting me continue but isn’t it obvious that FMD should be placed in the “too tough to figure out file.”? Dithering about trying to come up with investment schemes such as FMD is specious whatever the reasoning. Why? Because, talented and driven people — like you, Cog — should move on with your brain to more “sure things” and pass — however fun and wonderful to muse on, etc. — on the investment schemes that will, in the end, lose more money than they make. Regarding Buffett and reasoning–where to begin? No impertinenance intended but I believe Buffett to be emotionally stilted and child-like outside his cloiseted little world of investments. How he reasoned that it was best to dedicate himself to his work to the great expense and well-being of his kids and wife is beyond me. The whole thing with Astrid Menks and wife Susan moving to San Fran was explained away. Don;t get me wrong, I’m glad he did but what book of wisdom allows for this type of behavior to stand? Oh, but I guess much is accepted / excused to such a “great” man. I don;t think he’s a great man at all. He’s a fine man but great, hardly. One of the only thing Buffett’s done better than managing his way to an amazing fortune is craft his image the way he has (whose real persona, I would bet, is a bit unlike this “cornfed capitalist” image crafted by Buffett and aided by flattering press). So, I personally don’t have to look far to see some of Buffett’s mistakes in reasoning. But, I could well be wrong and possibly he’s the only one who well reasons about everything (which I find an absurd statement). So, in conclusion, all your reasonings re. FMD are specious because they’re worthless in the end. That’s the danger of thought–one just got to know when they’re thinking too hard on something. Go for the singles and doubles and then look / wait for an occasional triple, super-homer, etc. And my quote re. the mathematical horse (wh. is a Samuel Johnson quote) is not dissimilar at all to my argument of passing on FMD specualtive investments and concentrating on larger true investments. Let’s say you feel I’m full of beans and concentrate your efforts on finding the FMDs of the world–fine. But in the end if you’re correct, how do you gain if you can only put only so much in it. FMD ventures and the like are for amateurs. And from what I gather you’re not one of them. I like your reasoning but it’s simply a waste of time dithering with it. (Of course, it’s your time so don’t mind me telling you what to do with it … that’s not the point of my writing. The point is that the investment world is full of idiots and I hope you, with your brain / personal drive will use it in a positive way). Look at it like this … you can sit around and decide what flake jacket to wear to a party you hope to go in a section of town known for its violence … you put a probability on getting shot and then decide your chances coming out alive would be best managed if you wore X flake jacket vs. the Y flake jacket. So, you put on the X flake jacket and go to the party. This is the same reasoning you use in the FMD investment. I would say another line of reasoning would be to simply skip the party and go somwhere and party where the chances of getting shot is nil.
Polemics aside, maybe a return to the original problem will be helpful. Options are typically a speculative investment, but are there times when it makes more sense to buy options than shares in the common stock?
The situation of a company facing an inability to continue as a going concern and possible bankruptcy means that if the worst comes to pass, the stock will go to zero (obviously). If, however, it manages to avoid this fate and survives, the stock price will zoom.
In a way, the binary nature of possible outcomes makes the common stock a kind of option with expected value presumably baked in.
How does this compare to an investment in an option for the stock of the company? In this scenario, again the worst that can happen is the company goes bankrupt and the options goes to zero. However if the company survives, the value of the option will be much greater than that for the common stock.
Downside in both cases is zero and the likelihoods are the same. However upside is very magnified in the case of the option vs the common stock. If in this situation, an investment in the common makes sense, an investment in the option is a better play since expected value is far greater.
A good discussion of this can be found in Joel Greenblatt’s book covering his investment in Wells Fargo during the California real estate scare of 1990.
I hope this sheds some light.
I wasn’t aware of WEB’s use of options in his early years. Where did you read this? It’s doubly strange given the fact that Black Scholes didn’t come around for a few decades.
Paul,
Thanks for clarifying my argument. Now I want to reread You Can Be A Stock Market Genius.
JAF is right in arguing that any position in FMD is speculative for OPMI’s (outside passive minority investors). Furthermore, if you can only put a little money into something, it isn’t worth doing. However, if you can’t resist taking a position, options are preferable (possibly a $5 strike price). JAF and I have been arguing different points while actually concurring.
I remember Buffett saying something along the lines of: “I’ve been involved with puts and calls since I was a kid.” Maybe he was talking about working as a stockbroker?
I have looked into FMD a bit and I liked the business model. The main problematic points are 1) the earnings are non cash 2) the accounting assumptions are as yet unproven (the earliest trusts have not yet matured and started releasing excess cash) and 3) they are wholly dependent on securitization markets being available. Until last year questioning that last assumption would have been regarded as insane. Mainly because it has never happened before.
LEAPS make sense ONLY when buying the stock makes sense. And buying deep in the money LEAPS provides you some margin of safety if things take longer to play out. But I agree that any investment worth making is worth making in size.
Obviously options have existed long before Merton, Black, and Scholes, but pricing was inefficient (although not according to Nassim Taleb) and liquidity was scarce. Perhaps Buffett was involved in riskless arbitrage transactions by creating hedged positions where chance of loss was zero. Imagine an option with negative intrinsic value (strike price + option price < common price). In this scenario buying the option and shorting the common in equal numbers creates a perfectly hedged position. It is known that Ben Graham engaged in similar practices with common/preferred stock hedges and convertible/common hedges. Again relying on market imperfections in pricing.
In my view, there are definitely many implicit errors in much of the reasoning here.
First, the argument is very academic and when you talk about “probabilities” there is an implicit assumption that you’re actually talking about the RIGHT probabilities. If Buffett looked over the same circumstances as you, how different would your assumed probabilities be?
Also, look at this statement: “Obviously it is better to potentially gain 13 times your principal as a LEAPS holder than 4.5 times your principal as a shareholder.” Well yes, but this assumes that the market actually moves exactly the way you want it to within a specified period of time. This “reasoning” is the fool’s gold of finance. It is the flawed thinking that comes out of college finance courses — smoothness, precision math, predictability, which leads to “strategy.”
In practice, those assumptions are deeply unsound. The markets are much wilder than the academics or value pundits would like you to believe, that is, when you actually have your real money on the line and are not just working with hypotheticals. In my experience of trading time-sensitive instruments, from commodities to currencies or even “work-outs,” events rarely unfold the way you’ve theorized. You figure, all of Modern Portfolio Theory — which is deep, deep bullshit — is based on the type of mathematical reasoning that you use.
Moreover, the difference between the options and the equity is the difference between doing a trade and owning a stake in a business. Granted, acquiring a stake in a business with call options to lower one’s cost basis is definitely a sound strategy used by Nelson Peltz, Bill Ackman, Carl Icahn and many others. But these contracts are negotiated with the big investment banks and aren’t possible for the small guy. In fact, total return swaps are even better.
Options are rat poison for small investors, and the spreads are ridiculously wide. So what you’re suggesting is essentially a poor man’s total return swap strategy, using Scottrade, and it’s just an insane thing to be trying. Would a real businessman think like this? Would Warren Buffett advise shunning equity stakes in quality businesses to gamble on bankruptcy candidates in hopes of hitting it big?
And realistically, if investing was as simple as a high school statistics course, wouldn’t there be millions more successful investors? As opposed to a mere handful? Don’t you think Bill Miller knows all of the same value dogma you’re spouting — so why did his portfolio include Countrywide Financial, Bear Stearns, Citigroup, Fannie Mae, and so on? Miller actually hangs out with Buffett! So then why are his results such a nightmare?
Why are there innumerable examples of Harvard graduate value managers and every other type of slick investor and financier with results ranging from mediocre to horrific? Don’t you think that something is missing here — that simply reading all the value investing books isn’t good enough?
Mark Sellers gave one of the greatest talks I’ve ever seen at Harvard Business School about this exact topic — what it really takes to be a wildly successful investor — which you can read here:
http://www.beearly.com/pdfFiles/Sellers24102004.pdf
If you really want to have faith in the “probabilities,” your best course of action would be to get a Vanguard index fund and give up your attempt at active investing. Your chances of success with the latter are basically lottery odds.
As an anonymous writer, you have the right to give advice of all kinds without taking responsibility for what is said. You also mention your experience without substantiation, just as many of the people I encounter on Wall Street. If you are truly a successful investor, show me your account statements; numbers do not lie, because they have no ego. I will not continue this debate unless you put yourself “on the line” (i.e. provide a name, website, place of work, etc.).
You are guilty, at least to some degree, of Monday morning quarterbacking. Your argument would appear far weaker if it had been made in mid-July, when FMD was only $1.70 a share. The current price of $4 should give you no special confidence. Before GS Capital Partners’ recent investment, there was a considerable chance of First Marblehead going to zero.
It would have been courteous of you to quote my entire thought rather than just a fragment of it. I wrote, “Obviously it is better to potentially gain 13 times your principal as a LEAPS holder than 4.5 times your principal as a shareholder. On the downside, it is also better to be a LEAPS holder, since only $70 is at risk as opposed to $360.” Without the second sentence, of course my argument seems absurd; you make it seem as though the upside was the only value I expected. I did actually include the downside. The weak part of my argument, admittedly, was assigning probabilities to the outcomes.
To answer your remaining points succinctly I will quote a previous response:
None of my statements is an unqualified recommendation to “gamble on bankruptcy candidates,” as you have inferred. (My recommendations always include “opportunity” in the title.) I only stated that the options were ideal if one had to bet. Please read carefully; it is a waste of time for me to defend positions that I never took.
Incidentally I should state that (1) I am skeptical of the utility of statistics and Modern Portfolio Theory and (2) I am not a typical “value disciple.” In many essays I criticize the traditional approaches you accuse me of “spouting.” (Please compare StableboySelections.com to other blogs; the philosophy and methodology are unique.) My mental energy is devoted almost exclusively to arbitrage and hedging, with the results shown. I have dealt with options since age 16 (most “value investors” never start), but my technique will remain a secret.
Well isn’t the point of blogs and message boards to discuss things in an anonymous fashion? Isn’t it like Internet dating – that no matter what someone says, when you meet in person you see that they’re a little fatter and little shorter and a little uglier than you were led to believe in cyberspace?
You want me to show my “account statements” – that is absolutely ridiculous. In fact, it is hypocritical to say that you judge Warren Buffett purely on the soundness of his reasoning, and then turn and demand to see my credentials and financial records.
You’re committing an ad hominem fallacy: you’re trying to attack me instead of my argument. And I’m not offering “advice” – getting a Vanguard index fund? – but instead am asking questions, stating facts, and offering logic to illuminate mistakes in the above argument. Thus, you should address my argument, not demand to see my ID.
I don’t follow First Marblehead at all. What I was trying to say is that it is very difficult to “time” the market, which is essentially what you’re suggesting with options. I’ve seen distressed stocks selling for $3 per share but with $5 in earnings power that I said could never go lower – and then they dropped to $1.50. If I were on margin, I would’ve been wiped out (only to have the shares skyrocket afterwards).
There are numerous stories of short sellers who’ve said that some technology high-flier couldn’t go higher – and then it doubles in value and they’re wiped out. Look at Bill Ackman with MBIA: he was short since 2002. If he owned puts, they would have expired worthless, despite being totally correct about the position.
And there are plenty of examples of great companies whose shares stay depressed for years – sometimes because of exogenous shocks, sometimes because of recession, sometimes for basically no reason at all. If you’re using LEAPs, they would expire worthless. There are innumerable examples of this. The point is that all of these techniques are dangerous in practice – precisely why Warren Buffett recommends not doing them.
You can’t time the market and if you’re using time-sensitive instruments then that’s what you must do. And one large mistake will dramatically impair your rate of long-term compounding. Why do you think so few people compound at 30%?
And the point with my Bill Miller example was that mistakes tend to come in clusters – you own ten banks and think you own ten banks, yet when the credit crisis hit, you effectively owned one bank. This is the type of thing that traders like Bruce Kovner or George Soros will tell you, and it is true. With the systemic component of risk – and in the face of contagion, or a reflexive process as you outlined in a different post – you can have several strong companies that, ceteris paribus, would have been fine. But in the face of an exogenous shock, they are all decimated. Read over financial history, even from only the early 1900s until today, and ask yourself whether exogenous shocks are isolated events or the norm?
There are arbitrage situations that fall apart and hedges that fall apart. Value investing tends to be thought of in a static manner, where the markets are complex and dynamic.
If achieving massive success in business and finance – exalting oneself to the top, what, 0.001% of the world’s population in terms of wealth? (the percentage of people in the world worth more than $30 million) – is as simple as reading all the commonest investing books on Amazon, then why can’t more people do it? Seriously, out of 6.6 billion people in the world you’re trying to be amongst the top 0.001% in terms of wealth? And $30 million is chump change! That’s what one of Bill Ackman’s Manhattan apartments costs! And he’s got several!
In other words, out of 6.6 billion, you’re trying to be one of the lucky 6.6 million who get the golden tickets? And you really think that you’re going to piece together the correct string of bets in the chaotic financial markets to achieve a perfect record of 20%-30% over the long term in order to achieve this result?
What is the probability of that?
I will not rebut any of your points as I feel they are sound. In terms of content (and writing style), you resemble Nassim Taleb—a thinker whose views I generally accept. The only problem with this comparison is that Taleb regularly buys out-of-the-money options.
Your last few paragraphs do not belong on this site. In at least 10 essays I have written that market prices are quite efficient—a heretical claim among “value-oriented” investors. Of course EMH, like the existence of God, is neither provable nor falsifiable; but the confirming evidence is strong, with only a few conspicuous exceptions. I have a draft prepared on this topic titled “Inventiveness, Secrecy & Market Efficiency.”
Haha well, I haven’t read Taleb’s stuff outside of a few magazine articles, but I get his general ideas and they are correct. What I also know about him is that many of his ideas are not original but lifted from others who had expressed them in a more abstract and mathematical form. As for his options strategy, my feeling is that he shouldn’t quit his day job of writing books.
With EMH, of course it is falsifiable:
http://www.forbes.com/lists/2008/10/billionaires08_Warren-Buffett_C0R3.html
He offers 62 billion reasons for why it is wrong. I’m sure you’ve heard the “bum on the street with a tin cup” remark. I don’t know the academic definition of market efficiency, but markets are definitely not efficient in the way that most people understand that word.
It depends on what type of “efficiency” you’re talking about. Many value investors have gone out of control with ridiculing the markets, treating them as clueless, drunken, and easy to take advantage of. And many of these investors’ embarrassing performance illustrates that things might not be so simple.
Day in and day out, the markets are efficient. Millions of shrewd investors are not going to be blithering idiots. If you take a Selfish Gene view of the world, the stakes are life or death. Yet, it is also important to note that inefficiencies are extremely difficult to take advantage of precisely because there are often very considerable barriers to exploiting them. Moreover, there are all different varieties of inefficiencies.
Many are a result of the under- or overvaluation of a certain event or circumstance. For example, political risk. Or look at the long-term economics of the U.S. dollar relative to the Chinese renminbi or Japanese yen, where traders fixate on the immediate term at the expense of massive imbalances that will result in historic secular shifts. The powerful incentives for relatively good short-term performance also contributes to inefficiencies.
In mainstream value investing, information cascades and self-fulfilling prophecies are becoming increasingly common. Look at the “glamour” value stocks and copycat strategies, as well as extremely vocal short selling.
Some inefficiencies are mechanical in nature — such as forced sales by index short sellers, indiscriminate institutions, and so on. For example, many big institutions have indiscriminately sold small-cap financial and real estate companies because, in an imploding sector, it simply isn’t worth their time to research a highly complex company worth $200 million or less. You’re going to spend hundreds of hours researching a company that won’t move your bottom line?
The point is that inefficiencies arise for subtle yet complicated reasons, which often have considerable barriers to exploitation. Here is one of my favorite articles on this issue, by the Princeton economist Alan Krueger:
http://www.iht.com/articles/2005/04/28/business/bubble.php
Look over recent financial history — from tech stocks, real estate, Chinese stocks, credit instruments and the big dislocations in agricultural futures markets.
Something is unequivocally wrong with the academics’ theory. Markets are not always efficient. Not even close.
-Nicholas E. Radice
Nicholas,
I am familiar with your views on market efficiency as they have been expressed by several prominent “value investors.” The great difficulty with this argument is how to define an inefficiency. I will not be able to give you an adequate response until next week.
My argument is the same as that of prominent value investors? I can see maybe the part about index short selling, but political risk and exchange rates? Copycat strategies? Since many (if not most) prominent value investors are copycats, with the obvious exception of guys like Buffett, I can’t understand how they would hold my views? And I am sure they don’t think in terms of barriers to exploitation, since I created that term myself.
The reason market inefficiency is so hard to understand is that people seek out rules, whether mathematical in nature, or even in terms of a game, like bridge. I once heard Soros remark that the one thing you must always be cognizant of in finance is that it is a game where the rules are constantly changing.
Buffett intuitively realizes this as well, hence his transformation from Grahamian value investor to the Fisher franchise buy-and-hold strategy, and now into a Soros-like global-macro trader in commodity futures, index derivatives, demographic shifts, foreign businesses and exchange rate speculation. Humans naturally seek out some form of “truth” in life; yet in finance, the truth is constantly in flux.
Modern inefficiencies are more a matter of perception than fixed quantities; that is, until the market snaps back to a state of equilibrium, as it is now.
A few people are wired to take advantage of it, most aren’t. The vast majority of human society is organized into hierarchies where people advance themselves by being the most obedient and zealous followers — in school, corporations, religion, the military. And those are exactly the traits that lead to failure in investing. Most bright people are trained from a very early age to think in a manner that advances them in society, but is at odds with the decision-making abilities that are necessary to become successful investors.
-Nicholas E. Radice
I should have written that only some of your views on market efficiency have been expressed. Nonetheless I still believe that the main problem is how to define an inefficiency.
A great analog of your second point–that the rules are constantly changing–can be found in Robert L. Bacon’s Secrets of Professional Turf Betting. He writes:
I agree with your main point; it is probably the most important idea in investing.
I would define an inefficiency as a breakdown in the fundamental relationship between risk and reward. If an asset is priced such that you have a very high probability of excess gain and a very low probability of loss, that is an inefficiency or undervaluation. Conversely, if an asset is priced such that you have a very high probability of loss and a very low probability of gain, such as dot-com shares in the late 1990s, then you have a different form of inefficiency, or an overvaluation.
Yet, these are also associated with the participant’s bias, meaning that most market agents have a misperception of reality and thus believe that the asset is correctly priced. In other words, they are either undervaluing or overvaluing reality, as a result of their own perception.
The mainstream and variant perceptions all have different views on an asset, and the price clears because most people do not see whatever the true inefficiency is. Thus, to have an inefficiency, most people must vote that the market is, in fact, efficient.
And clearly other elements come into play as well: boom-and-bust processes, self-fulfilling prophecies, information cascades, dysfunctional pricing models, barriers to exploitation, panic, euphoria, whatever.
To define it academically, one would need to draw from the research in dynamical systems, behavioral finance, game theory, and several other areas. You really have to look at the history of financial theory to recognize the flaws in it, and the flawed framework that it was built upon. The irony is that financial theory and much of economic theory was modeled after 19th century physics; yet with the birth of quantum mechanics and relativity, physicists no longer look at the world in the same way. The logical underpinning of financial thinking is literally outdated by 200 years.
With value investing, most investors have been told to look for historic Grahamian investments like Western Insurance — gross distortions of prices relative to an easily-quantifiable value. Yet that mode of thinking arose out of the Great Depression, after which investors overvalued the risk premium in stocks, and those situations essentially disappeared in the 1960s. Similar situations may pop up here or there, but with millions of smart people combing the financial markets every day, it is extremely rare to find a thriving business or quality asset that is priced at dramatically less than what it is worth. There is almost always some other angle on the situation; modern inefficiencies take a much more complex form.
-Nicholas E. Radice