Chapter 3: Paul A. Samuelson – The Worldly Philosopher

Ø The ambitious goal of leading theories in the field of finance represents a powerful idea: the forces can be unleashed to improve the functional resemblance between the markets in the real world and the markets as they are defined and described in Capital Ideas.

Ø Although reality may never duplicate the way information is disseminated and comprehended in the EMH, the positive and systematic correlation between risk and return as defined in CAPM is coming closer all the time.

Ø Samuelson still believes there are no easy pickings in the stock market. Even when somebody’s track record indicates they have outperformed the averages after adjustment for risk, i.e., alpha.

Ø Benchmarks are mushy, risk measurements are arbitrary, and what we want to classify as alpha, or beating the market, if often just the return to systematic risk, or beta. Previous alpha tells you nothing on the future alpha.

Ø Samuelson notice that people are not time consistent, and they often try to control themselves with decisions designed to bind their future, such as the “behavior of men who make irrevocable trusts, in taking out life insurance as a compulsory savings measure.”

Ø However, Samuelson also pointed out that most investors “do not even understand how to capitalize on the behavioral anomalies, even if they are skeptics about efficiency and fans of behavioral theories. Indeed, part of their own irrationality is their unwillingness to accept the volatility and kinds of risks that do average out to be profitable.”

Ø Samuelson à the existence of positive alpha somewhere is not an exception to the EMH but a kind of vindication of the logic of it. It is efficient for that alpha to be corrected and it is logically implied that those with better info have to make money.

Ø Samuelson does agree that we cannot take the EMH as dogma, but he also believes most evidence of beating the market is merely hot hands – a run of good luck.

Ø Samuelson: “My twist is that modern bourses display what I like to call Limited Micro Efficiency. So long as a minute minority of investors, possessed of considerable assets, can seek gain by trading against willful uninformed bettors, then Limited Efficiency of Markets will be empirically observable.”

Ø My pitch on this occasion is not exclusively or even primarily aimed at practical men. The less of them who become sophisticated, the better for us happy few.

Ø Speculative prices behave like what mathematicians called a ‘martingale,’ where in the nest period prices may as likely change more than the total market index or change less.

Ø Frank Fabozzi: “It is a paradox but nevertheless true that stock prices are so hard to predict because stock prices are themselves predictions of the future.”

Ø This kind of complexity in the behavior of markets leads stock prices to have momentum in one direction in the short run but tend to reserve the momentum over the longer run as more info becomes available.

Ø The market reverts toward the mean in the long run because investors finally begin to recognize that it is “too high” or “too low.” (i.e., there is always a drive toward efficiency in the market, and it becomes most potent when prices have moved far enough away from equilibrium to lure investors to change the market’s direction.)

Ø Samuelson concludes: “No book can make you rich; few can keep you rich; many will speed up your loss of fortune.”

Ø Samuelson ultimate conclusion: “wide diversification of portfolios is the canny way to sleep nights and husband one’s life-cycle savings”

Samuelson recognizes that there are few who can outperform. The trouble is that you and I can’t identify that special few. But suppose we can? We can’t buy their prowess cheap. Stubbornly looking for them can cost us dear.