Randomly Walking in Circles?

In his April 2003 working paper entitled “The Efficient Market Hypothesis and Its Critics”, Burton Malkiel, author of A Random Walk Down Wall Street, contends that “a blindfolded chimpanzee throwing darts at the Wall Street Journal could select a portfolio that would do as well as the experts.” Has recent work of the behavioral finance community and the pattern-finders changed his mind?

In a word: No. He argues against a range of competing research that claims discovery of market inefficiences, such as:

• Short-term momentum, including underreaction to new information;
• Long-run return reversals;
• Predictable patterns based on valuation parameters, including initial dividend yields and initial price-earnings multiples;, and
• Cross-sectional predictable patterns based on firm characteristics and valuation parameters (size effect, “value” stocks).

He explains the findings of others as follows:

“Many of the predictable patterns that have been discovered may simply be the result of data mining. The ease of experimenting with financial databanks of almost every conceivable dimension makes it quite likely that investigators will find some seemingly significant but wholly spurious correlation between financial variables or among financial and nonfinancial datasets. Given enough time and massaging of data series, it is possible to tease almost any pattern out of most datasets. Moreover, the published literature is likely to be biased in favor of reporting such results. Significant effects are likely to be published in professional journals while negative results, or boring confirmations of previous findings, are relegated to the file drawer or discarded. Data-mining problems are unique to nonexperimental sciences, such as economics, which rely on statistical analysis for their insights and cannot test hypotheses by running repeated controlled experiments.”

He concludes:

“[B]efore the fact, there is no way in which investors can reliably exploit any anomalies or patterns that might exist. I am skeptical that any of the “predictable patterns” that have been documented in the literature were ever sufficiently robust so as to have created profitable investment opportunities and after they have been discovered and publicized, they will certainly not allow investors to earn excess returns.”

In summary, Burton Malkiel continues to believe that the stock market is inexploitably efficient.

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