Forget trends and patterns: Randomness rules the stock market

Despite impressive evidence that most short-term movements in the markets are random, professional and amateur investors alike continue to throw hundreds of billions of dollars at strategies designed to beat the market. The common perception is that certain securities are “mispriced”—that is, investors have bid them too high or too low based on their inherent value.The human mind has evolved over millions of years into a highly skilled perceiver of patterns and creator of order. These attributes have led to wonderful scientific discoveries, sublime art and music, and complex social structures and societies. In those areas, as in many others, our ability to detect pattern and order is desirable. Unfortunately, in other areas, such as the investment markets, our order-demanding brains can be a handicap.

Two of the academic world’s most famous financial researchers say there is just too much “noise” in the daily price movements of stocks to allow for the detection of any patterns that can be used to actively manage a portfolio. “People just don’t appreciate noise” The man on the street—or even a good MBA student—has a hard time embracing randomness,” Kenneth R. French, a finance professor at Dartmouth, told the Journal of Indexes recently. French has done groundbreaking investment research with Eugene F. Fama, a business professor at the University of Chicago, which shows that market efficiently accounts for new information about stocks, re-pricing them too fast for one investor to gain an advantage over another.

Fama developed the “random walk” hypothesis, which demonstrates that short-term movements in stock prices do not follow a pattern. Fama and French also conducted groundbreaking research that indicates virtually all returns in a stock portfolio can be explained by just three factors: the portfolio’s overall exposure to the market, along with its exposure to small stocks and value stocks. French believes that research into the behavior of investors shows that “people’s perceptions are not consistent with reality.” Fama agrees.

In the interview with the Journal of Indexes, Fama noted the problems caused by financial journalists. “If writers took the evidence seriously, they would have a lot less to write about,” he said. He noted the quarterly review of mutual funds that appears in the Los Angeles Times. He said the survey continually shows that passive mutual funds—those that track indexes or large market segments without making judgments about individual stocks—consistently outdo actively managed funds that try to beat the market. “And you know the lesson they draw from that?” he asked. “That you have to pick your active funds more carefully.”

The real lesson, according to Fama and French, is that investors would do best by putting together a broad portfolio that captures the entire market and that tilts towards small and value stocks. “It’s the noise that people don’t appreciate,” French said in the interview. “They want to draw much stronger conclusions. If it weren’t for noise, 98% of investors would see what’s going on and buy passive strategies.”