Viewing The Market As Organized Chaos

December 17 2011| Filed Under » Capital Market, Financial Theory, Organizational Theory, Warren Buffett
There are two competing theories in the financial world: the Random Walk Theory and the Efficient Market Hypothesis. In the random market you can spread the financial section of the "Washington Post" on the floor and toss pennies on it, picking the stocks that a penny lands on, and expect the same results as a professional stock picker. In the case of an organized market, you can choose stocks based on a system of valuations and, coupled with a world of full disclosure, come out ahead of the penny tossers.

The theories clash and the debate rages, but with a little help from 20th-century physicist Erwin Schrödinger and a cat in a box, we'll learn that both theories are correct and incorrect, depending entirely upon your vantage point. Read on to learn how the market is just like a cat in a box, and how the entire history of the market can be viewed as a massive forest, with investors nothing more than short-sighted insects crawling across its surface. It's going to be a wild adventure.

Two Worlds One Cat
Not many people would draw similarities between quantum physics and the financial markets, but this type of unconventional thinking can shed light on the random market versus efficient market paradox that Wall Street lives under.

In the 1930s, Schrödinger was puzzling over why the laws of physics that govern our everyday lives are so difficult to apply at the subatomic level. Essentially, at subatomic levels, particles needed to be in more than one mutually exclusive state at the same time. A difficult idea to wrap your head around. The thought experiment he came up with to explain this is now famous. It involves a cat in a box. Along with the cat, inside the box you place a vial of hydrocyanic acid with a hammer suspended above it. There is a switch attached to the hammer that will cause the hammer to drop and break the vial. Next, you attach a Geiger counter to the switch, making it so that the switch will trip if the counter registers any radioactive activity in the box. Finally you place a very small piece of radioactive material inside the box that has a 50-50 chance, each hour, of releasing a particle. Now you can probably guess how this elaborate system all comes together:

1. A particle is released.
2. The Geiger counter senses it.
3. The switch is flipped.
4. The hammer falls.
5. The vial breaks.
6. The kitty dies.

Ah, but wait. It is equally probable that a particle wasn't released and our fuzzy friend still lives. Now, if we open the box after an hour we'll know for sure. However, if we don't open the box and do not observe, then the kitty is neither alive nor dead. It exists in both states simultaneously. The observation itself affects the outcome. This is sometimes called the "observer's paradox."

Now, let's jump back over to the world of investing and our own paradox. Remember, there are two states for the market, random and efficient; the penny tossers versus the market scholars. Those who believe things are random have plenty of observable evidence to prove that it is random, so too do those who believe it is efficient. However, as with tearing the box open to see the cat, observing the market has an effect upon the results. Let's move to the jungle to see how this works. (To learn more, check out Efficient Market Hypothesis: Is The Stock Market Efficient.)

Where the Wild Things Roam
When we scrutinize the market as a whole, there does seem to be a lot of unpredictability. If you were to tilt the stock market's history on its side and then convert every listed company into a plant, you would see a vast forest with thousands of plants shooting up and dying in seconds and clutches of saplings and trees here and there. Some of these trees would start from separate roots only to grow together and split again. Some of the grasses may spontaneously become a sapling or be absorbed by one. The random market proponents are like ladybugs. From their vantage point, the world is chaotic and random. Which plants (companies) thrive and succeed versus those that die off and fail is unpredictable and overwhelming. (To learn more, read Mad Money ... Mad Market?)

It is the inability to see everything that makes stock markets look random. Rush hour traffic looks like chaos when you are in it, but from far above it looks as well designed as the circulatory system. This is where a structured market comes in. You have to make generalizations and somewhat marginal decisions to clear-cut the forest and get down to a few promising plants. In a truly random market, this would be impossible.

People like Warren Buffett, however, continue to prove that both structure and chaos exist simultaneously. Buffett is an expert at generalizing and, if you read his letters to his shareholders, you will realize that he rarely speaks about specifics.

The Buffett Paradox
The Oracle of Omaha proves that there is a structure to the markets, but he also states that he doesn't believe the markets are always efficient. If they were completely efficient, he wouldn't be able to beat the market because everyone would act in same way, buying the exact right stocks at the exact right time. If the market were completely random, he would be a statistical anomaly of immense size. In truth, Buffett and many of the other market mavens profit from moments of chaos and inefficiency in an otherwise efficient market. The inefficiency is all the other people involved in the market. Investor reaction, either overreaction or a lack of reaction, to the data is anything but predictable.

This uncertainty is what makes trading in growth stocks so exciting. You are not looking at the companies represented by the stocks, companies that are in all likelihood trading at many multiples of their earnings; intsead, you are trying to understand the reactions of other investors toward that stock. There are some people who are very good at this, more who are occasionally good at it, and the rest who break even if they are lucky, but often do worse. Even the introduction of structure to the practice of trading, in the form of new metrics and computer software, has not been able to tame the uncertainty. This uncertainty exists in all parts of the markets, but it has the most pull in growth stocks where ranks of traders and analysts cultivate it for their own ends. (To learn more, read Venturing Into Early-Stage Growth Stocks.)

Choosing Your Own World
You, as an investor, control what the market is in a very real sense. If you approach it believing it to be random, you will see a lot of numbers arbitrarily flipping about on a graph or newspaper sheet. These numbers will coalesce in patterns that start you down the path to day trading. When you make a mistake, you will attribute it to the unpredictable nature of investing. You may also become skilled at tossing pennies. (If this theory appeals to you, check out Day Trading: An Introduction, Would You Profit As A Day Trader? and Day Trading Strategies For Beginners.)

On the other hand, if you approach investing like you would approach learning how to become a surgeon, you will see that there are forces at work that generally act the same in all situations: bubbles burst, companies with advantages flourish, people need goods. You will also see that, like surgery, there are instructions and techniques to help you get better results. True, there are people who invest successfully owing to some inner talent, but talent will only take you so far. Most people need some form of a blueprint and a grasp of the fundamentals first or they end up with a dead bodies and malpractice lawsuits. (If order and structure are more your style, check out Using The Price-To-Book Ratio To Evaluate Companies and Warren Buffett: How He Does It.)

The Bottom Line
In order to be an effective investor, you have to do what quantum physicists do, consider the market as both random and efficient. There will never be a perfectly efficient market as long as there are investors buying into it. This doesn't, however, mean that the market is so random that no effort on your part can help you profit. You should never remove uncertainty, or by extension, risk, from your thinking, but you should act as if forces that are generally efficient rule the market. After that, leave the debate up to the economists who are paid to keep it going, because sometimes being a ladybug in a giant forest is enough to worry about on its own.