A Bachelian view of the markets
In 1900, a young mathematician named Louis Bachelier wrote a groundbreaking thesis, Théorie de la Spéculation, in which he outlined a case for modelling the financial markets under a condition of randomness.
“The influences which determine the movements of the Stock Exchange are innumerable. Events past, present or even anticipated, often showing no apparent connection with its fluctuations, yet have repercussions on its course….The determination of these fluctuations is subject to an infinite number of factors: it is therefore impossible to expect a mathematically exact forecast”(Bachelier, 1900).
As demonstrated above, Bachelier understood that day-to-day forecasts in stock prices were impossible to predict, and in the short term – the market was a voting machine rather than a weighing machine.
“Contradictory opinions in regard to these fluctuations are so divided that at the same instant, buyers believe the market is rising and sellers that it is falling.”
So, how can this history lesson help us as investors?
It means we can relieve ourselves of the worry of day-to-day market movements, and focus on what really matters; the economic value of an investment. That is: what income the business can distribute to you via capital gains and dividends over its lifecycle. This is best assessed by a thorough analysis of the firm’s competitive advantage, economic moat, profitability and future prospects.
Day-to-day fluctuations mean little, but large changes over time in the economic value of a business may lead to serious improvements or setbacks in our pursuit of wealth creation.
To a great extent, business economics are our only avenue for escape from an outcome of portfolio randomness; a scenario where we are most certain to lose.
This post was contributed by a representative of Montgomery Investment Management Pty Limited (AFSL No. 354564). The principal purpose of this post is to provide factual information and not provide financial product advice. Additionally, the information provided is not intended to provide any recommendation or opinion about any financial product. Any commentary and statements of opinion however may contain general advice only that is prepared without taking into account your personal objectives, financial circumstances or needs. Because of this, before acting on any of the information provided, you should always consider its appropriateness in light of your personal objectives, financial circumstances and needs and should consider seeking independent advice from a financial advisor if necessary before making any decisions. This post specifically excludes personal advice.
INVEST WITH MONTGOMERY
gareth hurst
:
Hello Scott,
It is interesting that someone in 1900 had such profound thoughts about markets. I find it interesting that you interpret his findings that day to day fluctuations in market prices are random as the Benjamin Graham quote.
I have always taken Benjamin Graham’s reference that markets are short-run voting machines and long-run weighing machines to mean that markets can be irrational in the short-run (providing investment opportunities), but rational in the long-run
The observation from Bachelier that “[e]vents past, present or even anticipated, often showing no apparent connection with its fluctuations, yet have repercussions on its course” could also be interpreted as investors’ using all the information that they can find to price assets.
Given that the future is unknowable, then changes to expectations results in changes in prices. If expectations are unbiased, then returns should appear random as Bachelier finds. If investors’ ‘vote’ in the short-run and this voting displays a systematic bias such as greed and fear, then prices would not appear random and forecast models using past returns could be used successfully.
I am happy to concede on this point but I though Bachelier’s seminal work was more closely related to the efficient market hypothesis than Benjamin Graham’s Security Analysis.
Asher Jebbink
:
In an ideal world we would all love to dismiss the daily noise but as someone who has invested in TMF so that I don’t have to wade through the noise, reports, et al., the price movement of the Fund is essentially all I have ‘to go off’ as an indicator of how my investment is going.
I know there are the bimonthly reports which show the top stocks in the Fund, however, that’s only a fraction of all the businesses invested in and is a lagged snapshot (eg: GEM has been rated pretty highly until very recently and I’ve since read the Fund doesn’t hold it anymore).
Not a complaint, just saying for those of us that don’t work in the industry or spend many hours a day following markets/businesses/stocks/etc, the price movements of the Fund and some of the known held stocks provides some (albeit short term) indication of how things are going.
Greg McLennan
:
Nice and succinct. Thanks Scott.