A random walk down Wall Street

It took another century and a half before stockbrokers admitted the stock market was a random walk. Like insurance, resistance to gambling analysis was not just a verbal formulation; it led to mispricing. Today, financial theorists agree that stock dividend yields should be lower than bond yields because stocks can appreciate (bonds will pay back either the promised amount or less-in that sense, they can only go down, so an investor needs a higher promised return to make them attractive). But until Modern Portfolio Theory was invented in the 1950s, stock dividend yields were higher than bond yields because stocks were considered to be riskier. Moreover, stock portfolios were improperly diversified and no one computed track records of managers because diversification and statistical performance measurement made sense only if stock price movements were random. Refusal to acknowledge the randomness of stock price movements created tax loopholes and irrational legal rulings.

The stock market claim looks particularly silly in light of the history of financial institutions. From the lottery to raise the funds for the founding of Jamestown, Virginia, in 1607 to the lottery used to pay the interest on Dutch loans to the United States during the Revolutionary War, the development of the United States was funded by gambling. Wars, churches, universities, and public buildings were all paid for by lotteries. The government encouraged private businesses to raise capital via lottery. As the financial system evolved, businesses began to issue stocks and bonds instead, so lottery brokers became stockbrokers. The two forms of finance coexisted throughout the 1800s. They even reinforced each other. Lottery companies sold stock, and bucket shops sprang up where customers could place bets on stock and commodity prices, without any underlying ownership. Only in the latter part of the century did people start to distinguish sharply between respectable investing and gambling, elevating the former and despising the latter.

When stock market professionals finally embraced tools developed for gamblers, they needed a defense. They couldn't claim that people bought stock to hedge other, naturally occurring, risks in their lives. Instead, they claimed that the risk was inherent to economic activity and the stock market simply allocated it to willing risk takers. This helped the economy grow by providing risk capital and meant that the inevitable losses from bad luck and miscalculation would be assigned to the people most able to bear them.

Like the insurance defense, that makes some sense until you think about it. Starting a business is risky-it might succeed or it might fail. If you put $100 into a new business, it could turn into $1,000 or zero. But if you put $1 into each of 100 businesses, you're much more likely to come up with something in between. You can't eliminate risk this way, but you can reduce it. This is called diversification. Like hedging, it's true enough in principle, but it is dependent on the scope of your analysis. Relying on it has caused more financial pain than gain.

If the stock market existed to convert inherent economic risks of individual businesses into safer diversified portfolios, most of the activity would center around new issues of stock. This is a tiny fraction of stock trading, and it takes place outside the stock market. Most of the risk experienced by market participants comes from short-term buying and selling of stocks with each other-risk that has nothing to do with raising capital for businesses or, indeed, any economic activity. Young people, who have the longest time horizon over which to diversify risk, should slowly accumulate index funds, then slowly withdraw from them after retirement. In fact, most money is put into the stock market by older people. Until fairly recently, among people who owned stock, the most common number of companies held was one.

In this case, practice is moving toward theory. Index fund investment is growing, and more young people are building up positions in the stock market. However, portfolios are still very far from what theoretical models advise, and the vast majority of research and news reporting about the stock market concerns the quest for undiversified short-term gains (hot tips) rather than diversified long-term returns. That makes no sense if the purpose of the stock market is to spread out unavoidable economic risk, but perfect sense if the purpose is to let people gamble.

If the stock market is supposed to allow investors to diversify business risk, no business should issue more than one kind of security. In fact, many companies have multiple classes of stock, some of which represent different types of bets on the underlying businesses (in other cases, the classes differ only in control rights). They can issue many different types of bonds, preferred stocks, warrants, and other securities as well. A few years ago, "tracking" stocks were popular, in which a company allowed investors to bet on individual subsidiaries. None of this promotes diversification of existing risk; it just creates new gambles for willing investors.

Intraday trading is the whole point of the stock exchange, and it serves no diversification purpose. If you sell a stock at 11 A.M., you get your money at the same time the next day as if you had sold at 10 A.M. or 3 P.M. There's no reason the exchange couldn't accumulate all buy and sell orders for the day and execute them all at one price at 4 P.M., the way mutual funds do. We wouldn't need all those brokers shouting and instant messages relayed to Blackberries and breaking news stock market shows on every minute the market is open. All the intraday trading is day traders making negative-sum bets with each other. Serious long-term investors would be perfectly happy to buy or sell once per day, and probably even less frequently in most cases.

Of course, without intraday trading, the stock exchange wouldn't be the stock exchange. The very essence of stock trading to a trader has no importance to an economist.

Another problem is that stock prices seem to move up and down far more than makes sense in economic terms. The extreme example of this was October 19, 1987, when the stock market fell almost 25 percent in one day, with no significant news. In less than three weeks, from the highest to the lowest point in October, the market fell by 40 percent. It's hard to explain that as inherent economic risk, and equally hard to tout the benefits of diversification when 1,973 stocks on the New York Stock Exchange go down and only 52 stocks (and mostly small, obscure ones) go up.

None of the largest stock market crashes on record were associated with any obviously significant economic news, either before or after the fact. Five of the top ten declines to date happened in the second half of October, with one more on November 6. In a modern economy no longer based on agriculture, that's easier to explain based on investor psychology than on economic fundamentals. If anything, October is a time of year of relatively little economic news: few extremes of weather, no major seasonal activity like Christmas or income tax day, uneventful times in construction and agriculture. U.S. elections are typically held in early November, but none of the crashes were in a presidential or otherwise significant election year.

For people who didn't like the "inherent risk of economic activity" argument, stock professionals had another argument. This one made more practical sense, but less theoretical sense. The claim is that investing in stocks is not gambling because the stock market has a positive expected return. Where is the gamble if the long-term investor always wins?

Everyone had always thought that when two people made a bet, both were gambling. In this new formulation, only the guy who got the worst of it was the gambler. The other guy was fulfilling some noble economic duty. In a reversal of older morality, the professional sharp was in the right and his or her hapless sucker was the sinner. Welcome to the 1980s, the decade when greed was good.

There are sensible reasons and some historical support for thinking stocks have a higher expected long-term return than bonds. But the case is by no means certain. Even if you accept it, there is a tremendous amount of risk in the stock market, even eliminating all the artificially added stuff by holding a low-cost, widely diversified index fund, and even over a time period of 20 years. So I can't accept the likely positive expected return as an essential difference between the stock market and gambling.

Дата добавления: 2015-10-26