A finance professor and his student take a walk together. Suddenly they see a $50 note lying on the ground. As the student stoops to pick it up, the professor says: "Don't bother - if it were really a $50 note, it wouldn't be there."Hahahahaa! Well, okay. If you don't know what the EM hypothesis is, you might not get this joke. Anyway, this Sunday, Mr Wang will take you on a whimsical "thoughts-affect-reality" tour of the world of finance.
Let's start with the basics. How do you make money out of the stock market? Very simple. You buy a share at a certain price, eg at $1.00, and later you sell it at a higher price, eg $1.50. There - you just made $0.50.
But in the first place, how do you know what to buy? There are three major schools of thought, known as fundamental analysis, technical analysis and the efficient market hypothesis. Let's take a look.
Intuitively, fundamental analysis makes the most sense to the layman. As the name suggests, you'll analyse the "fundamentals" of each stock. For example, you could start by analysing the general economy (eg the government's estimates for annual economic growth). Then you could analyse a particular industry within that general economy (for example, the financial services industry and the factors affecting it). Then you analyse a particular company within that industry (for example, DBS and its financial statements, its products and services, its business strategies etc).
You then form a view. You say, "Based on my analysis, the intrinsic value of this company's share ought to be $1.50." You then check the market. You find that the share is actually trading at $1.00. You quickly buy the share. In your opinion, the share is undervalued; people will realise it later; you're smarter than them, because you realised it first; and later you will be able to sell the share for $1.50. There, you made $0.50.
Mr Wang would say this: "Fundamental analysis assumes that there is an external objective reality. If we study this reality rationally, we can discover what that reality is. Using logical thinking, we will be able to identify the intrinsic value of the share. By using superior logical thinking, we can spot cheap shares faster than other investors, buy them up quickly, and sell them for a profit later."
Technical analysis is quite different. It does not care about the economy. It does not care about the growth prospects of any particular industry. It does not care whether the company's CEO has 20 years of management experience or had dropped out from primary school. All these factors are completely irrelevant in technical analysis.Technical analysis says that the market value of a share is determined solely by the supply and demand for it. Supply and demand depends on the hopes, fears, opinions, views, conclusions and guesses of numerous potential buyers and sellers - whether rational or not. All these factors are ultimately reflected in charts tracking the price of a share, the volume of trading etc.
Furthermore, chart patterns tend to repeat themselves. Terms to describe such patterns include "head and shoulders", "double top", "consolidation rectangles", "runaway gaps" and so on. From these patterns, you can predict certain trends that will continue for some time (that is, the price will either go upwards for some time, or downwards for some time, or stay approximately constant for some time). By studying the charts (and absolutely nothing else), you can predict which way the price is going to go. And that's how you make money, using technical analysis.
Mr Wang would say this: "Technical analysis assumes that there is an external reality, but that the reality is subjective. This reality is continually responding to the thoughts of investors, as a whole. If enough investors think hard enough that a particular share will go up, then it will go up. If enough investors think hard enough that a share will go down, then it will go down.
Thus it is a waste of time studying "objective", "rational" data such as the latest release of economic data or the level of political stability in Singapore. Just study the charts, whch represent all the investors' collective thoughts, which in turn move in predictable patterms. Study the charts, and you will know how the external reality will change in the future."
Now we turn to the efficient market hypothesis (also known as the random walk theory). It says that financial markets are so efficient at pricing in all available information that absolutely no one in the world can consistently predict the direction of the stock market or which stock will be the next winner.
For example, let's say that today, there is a terrorist attack in New York, or DBS announces its new business strategies for the next five years, or Microsoft appoints a new CEO. As soon as this information is released, it is instantly priced into the market. Investors, as a collective group, instantly take note of this information and the share prices of DBS and Microsoft immediately adjust, according to the opinions and views of investors, as a collective whole.
According to the efficient market hypothesis, fundamental analysis is basically useless. That's because every piece of information that the fundamental analyst is studying has ALREADY been taken into account. There is no point in studying the economy, or the industry, or any company, in the hope of finding a cheap, undervalued share that you can sell for a higher price later. Every available piece of information you're looking at has ALREADY been priced into the entire market.
The implication is that there is no rational way to find a "good" share to buy. There is no rational way to identify a "bad" share. Shares are simply whatever the entire universe of investors think they are. World-renowned finance expert Burton Malkiel goes so far as to say this: "A blindfolded chimpanzee throwing darts at the Wall Street Journal could select a portfolio that would do as well as the experts."
Here's another way to look at it - at any given moment, as long as the stock exchange is open, the price of each share is a perfect reflection of (1) all available information in the universe about that share, and (2) the sum total of all opinions, guesses, hopes, fears, beliefs, conclusions and expectations that all investors have ever had about this information.
Mr Wang would say this: "The efficient market hypothesis says that the present reality of a share's price is created by all the thoughts, past and present, that all investors in the universe have EVER had about that share. Furthermore, any new thoughts that investors may have about the share INSTANTLY affect the share. Time is pretty much an illusion."
Even instant karma, haha."