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Guest Blogger Mishlove: Ways of Picking Stocks

Good morning. We start off this week with a post from guest blogger Jeff Mishlove, while we still sort through the numbers from last week's trades. It's a timely post, about theories behind making picks for the contest (and perhaps your own personal trades--but remember this is a contest and we don't want to mix the two.) Here's Jeff on The Efficient Market Hypothesis.

My wife is a very efficient person. In fact, she teaches time management. Very few people are as well organized as she. Most are far more haphazard, especially when they engage in various forms of mass behavior. Why, then, is it proposed that the financial markets are efficient?

The efficient market hypothesis (EMH) represents mainstream thinking among academic scholars who study the financial markets. And, it is very relevant to contestants in CNBC’s Million Dollar Portfolio Challenge. Simply put, the hypothesis states that, at any moment in time, all of the known and knowable information about every financial security is already incorporated into the price. Therefore, it is virtually impossible to consistently gain an edge on the market through any rational means based on available information.

According to EMH, in its strongest form, the CNBC Million Dollar Portfolio Challenge is totally a game of chance. There is no skill, whatsoever, that can assist one in stock picking. Even if you do not agree with this hypothesis, it is useful to be aware of it. After all, it is a hypothesis, rather than a theory, because it has not been fully proven. And, in fact, it is not clear to me that it is truly a scientific theory – in the sense of being falsifiable. Proponents of EMH seem to have a long list of reasons why contrary evidence – such as the astonishing success of Warren Buffet and a score of other value investors – do not, and cannot, disconfirm their point of view.

The efficient market hypothesis, however, provides every investor, trader and speculator good reason for being humble. The main line of evidence in its support is simply that the thousands of professionally managed funds, overall, do not outperform the market as a whole. This simple fact has given rise to a new class of financial instruments, exchange traded funds (or ETFs), that allow investors to diversify strategies without the need of paying for more expensive professional money managers.

Of course, Portfolio Challenge contestants, have the opportunity on Friday evenings to listen to a host of so-called experts, including yours truly, expound upon market picks and strategies. And, many of us have been rather successful in making some spectacular stock picks. Proponents of EMH, naturally, claim that such hits are merely the results of chance. Children, they claim, throwing darts at the Wall Street Journal, could also come up with many spectacular stock picks. They scholars claim that, according to the laws of probability alone, the efficient market hypothesis predicts that people as successful as Buffet will come along (not to even mention students of forecasting such as myself).

Be assured that most professional investors, unlike most academics, do not subscribe to EMH. In fact, there are several alternative schools of thought – and that is why speculators speculate, forecasters forecast and traders trade. None of these professionals would be highly motivated if they thought their success was simply the product of random chance.

The first school of thought is known as fundamental analysis. The basic idea here is that one can gain an edge on the market by the hard work of becoming familiar with individual companies and their financial statements, understanding what makes them profitable, learning about competition, new products and services, the political environment, foreign markets, management, etc. The idea here is that, if you study harder than the next guy, you just might make more money.

Many EMH proponents grudgingly concede that fundamental analysis of this sort can provide some results – the key here being the possibility that, through hard work, one can dig out information that is not yet seen by the market as a whole. Of course, there is a cost to such research. And, ironically, many of the financial analysts who do this work have very spotty track records.

The next major competing school of thought is known as technical analysis. Technical analysts tend to agree with the efficient market hypothesis to the extent that they believe that the stock prices already embody all of the available information in the marketplace. Therefore they feel that there is little point in studying the fundamentals. Technical analysts specialize in looking at the history of price movements. They are especially interested in patterns of support and resistance as well as chart formations that gives clues to market psychology.

In general, academic proponents of EMH feel that technical analysis is a total waste of time. They do not believe that any solid, empirical evidence supports the idea of hidden profit potentials locked up in price histories. And, while technical analysts are forced to acknowledge the lack of scientific experiments that support most of their claims, they also can claim that their methods of computer analysis – including artificial intelligence and neural networks – are becoming more sophisticated each year.

A third school of thought is known as behavioral finance. This school is gaining ground among academics. Scholars in this area point out that many of the bubbles and excesses to be found in the financial markets cannot be explained by the rational behavior assumed in the efficient market theory. They note that it is very important to take human motivation into account as well as the enormous human capacity for subscribing to various fallacies. They study such phenomena as hindsight bias, overconfidence, the gambler’s fallacy and the illusion of control. While these scholars have made enormous contributions to our understanding of the markets, I believe none of them are known to have applied their knowledge to actual trading programs or stock market recommendations.

Actually, I find this whole debate to be rather analogous to the controversy surrounding parapsychology and psychic functioning. The academic skeptics of market forecasting are much like the academic debunkers of extrasensory perception. Contrary evidence is not enough to convince them that their ideas may be incorrect or incomplete. The similarity may even be stronger when one considers the possibility that highly talented market seers may, in principle, be using intuition or psychic functioning in their work. In fact, given the weaknesses of every forecasting method, intuition becomes absolutely essential. And, the proponents of both market forecasting and parapsychological precognition both bring impressive evidence and impressive results – from time to time.

The lesson in all of this for those of you participating in the Million Dollar Portfolio Challenge is to consider the possibility that your best stock market picks may unfold from seemingly random processes within your own mind. Logical analysis may only give you a slight edge – but not enough to achieve the outstanding success you will need to win a million dollars in this event.

In fact, I might add, in closing that my wife – who, as I mentioned in the beginning of this blog, is a very efficient person – is also very open to her intuitive side. I think it makes her more efficient, not less.

Jeffrey Mishlove is creator of www.forecastingsystems.com. He is also Dean of Programs for the University of Philosophical Research, a distant learning institution that offers masters degrees in consciousness studies and transformational psychology.

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