Douglas Goldstein: John Allen Paulos is a mathematics professor from Temple University
in Philadelphia.
He has written a number of books and one of them is called a Mathematician Plays the Stock
Market.
So John are you a fantastic stock market investor?
John Allen Paulos: I’m not sure there is such an entity, but I generally invest in
broad-based index funds and I don’t really think you can beat the market unless you can
front run and have all kinds of contacts and so on.
Douglas Goldstein: But there are a lot of smart guys like you who are mathematicians,
you think that this is really just a numbers game, why can’t they really look deep into
the numbers and find some answers?
John Allen Paulos: I mean people claim to be able to do so, there’s technical analysis
with all kinds of terms such as head and shoulders and floors and ceilings and so on, and a fundamental
analyst who look at profit and loss and all kinds of other qualities that characterize
a company, and can you make money using those techniques?
The answer of course is yes.
But the real question is can you make more money using those techniques and you can invest
in broad-based index funds and there it’s not so clear.
Perhaps if you devote your life to it, yes and have all kinds of help with computers
and contacts and whatever.
Douglas Goldstein: I certainly think a lot of people have devoted their life to it and
they’ve tried many.
In fact when I was younger, when I was still in high school my brothers and I both of them
are engineers, and this was in the day when our fast computer was an Apple 2 Plus, we
decided we were going to figure out the system and so we went to the library which for those
of you who are younger, it’s like a big building where you get a lot of data and we
looked on microfiche again for those of you who don’t know, it’s like looking at all
newspapers, just to get the closing stock quotes of the Dow Jones for a couple of years
and that was our database and then we ran formulas and ultimately, we found that we
were right, a little more than half the time which we thought was all we needed to make
money until of course we discover we were suffering from what’s known as I think data
leak which is our formula was actually taking into account the fact that we knew what was
going to happen but smarter guys than us, I’d like to think would be able to find
certain patterns that would repeat themselves, which is really what the technical guys say.
Why do you think that’s not true?
John Allen Paulos: If it were true, people not just technical analysts, but everybody
would gone on to it and arbitrage a way whatever small advantages they were, there might be
and then in fact that’s true for any kind of insight or whatever if you invest on the
second Tuesday in January or you wait for oil to do this and then you go big.
It might work but then next time it’s going to work far less well and people will arbitrage
you as I say, arbitrage the way, their difference.
I mean the market is in gross terms efficient, I mean new information is reflected more or
less quickly in the start, but it’s only grossly efficient.
I mean cognitive variables come in, behavioural finance, confirmation bias, all kinds of variables
to which we are all a subject but on the whole, it’s efficient.
There is an interesting paradox as regarding the efficient market and that is that the
market is efficient to the extent that people believe it’s not because if people believe
it’s not efficient, they’ll scramble around, they’ll look for every possible advantage
like you and your brothers did and by doing so, bring about efficiency whereas if people
do think it’s efficient, they’ll let their assets, language and the market will gradually
grow inefficient.
So again efficient to the extent that most people believe it’s inefficient, but it’s
broadly efficient with lots of deviations from efficiency and then you also have to
worry about fat tails and black swan so even if they expect the value is reasonable or
win let’s say most of the time, a very rare, horrible results will wipe that out so the
expected value might be negative even if on most years you do very, very well.
Douglas Goldstein: One of the things you said really kind of caught my attention which was
you said well some people say if you buy in the second Tuesday in January or you should
buy in the winter and sell in the summer, and there are a lot of these theories which
would seem to be reasonable when you back test them and of course I’m the first guy
to tell you that past performance is no guarantee of future returns, but it does seem that there
is something to these theories and there are many, many go we can go through.
Am I missing something, is it just random that these theories seem to work on average
over the years?
John Allen Paulos: If you look at stock funds, I mean the ones that are featured on the front
page of business magazines and newspapers, as being performing in a stellar manner in
2015 or 2014, they are just as likely to perform below average or even horribly the following
year despite the exorbitant salaries that managers of stock funds generally receive,
it’s like the sports illustrated cover jinx, I mean you’re right about people who do
well in this or that sport, the next month or next year they’re likely to do less well
regression to the mean.
But in a way it’s kind of a scandal, highly paid fund managers don’t really in the long
run do better than chance.
I mean people focus on when they do, do well but they neglect to look at them when they’re
not so well.
I mean just as there’s a cover jinx and the sports illustrated, the analog of what
I’m talking about would be the back cover, the player that did horribly.
Douglas Goldstein: Is this a similar concept to what people refer to as the black swan?
John Allen Paulos: Black swan is a very unusual generally negative result and people don’t
take account of but it’s just not that.
I mean just regular white swans vary a little bit and stock managers don’t generally do
better.
I mean they make money because whether market goes up or down, they’re going to make money,
there are lots of scams that are based on that, I don’t think we have time to go through
them but if you make money whether it goes up or down, in a way you don’t really care.
And there’s confirmation bias, I mean you talk about technical analysis, why don’t
people give it more credence.
One reason is that random returns are hard to recognize as random.
Random doesn’t generally look random.
One thing I do in my class is, is I have half the class go home and flip a coin 100 times
and record the sequence of heads and tails, and the other half just make up hundred symbol
sequence of heads and tails the way they think a coin would behave.
And the latter group, I can always tell when they hand in their papers the next day because
they don’t leave in enough runs of heads, enough runs of tails, the frequencies of runs
is far below what it should be and the total number of heads versus the total number of
tails goes back and forth, of course heads is a head, first part of the time then tails,
but that’s not what happens, there’s so called ArcSight Log shows that there’s equal
chance of whether heads or tails will dominate in this hundred-symbol sequence but whoever
it does, or whichever it does, it will probably dominate the whole time.
In other words, more heads at any given time have resulted than tails or more tails at
any given time will have resulted than heads and there are a lot of other behaviors of
random sequences that again don’t look random so people don’t have a good yard stick and
as a result they think things work when they really don’t in addition to cognitive variables
like confirmation bias and the effect and status quo bias and so on.
Douglas Goldstein: One of the things that I think a lot of people would say after listening
to quite frankly or rather pessimistic view of money managers is if you can’t really
get benefit, should you be investing in the stock market at all?
What do you think?
John Allen Paulos: I think yes, by enlarge.
I mean historically for lots of reasons, population, demographics, technology, improvement, the
stock market goes up.
I’m not saying don’t invest in the stock market, but as I say a broad-based index funds
generally go up, they have broad-based and low fee and you are not taking that much of
a risk but what that entails however is giving up this romantic illusion that you’re kind
of gun slinger who will go and really clean up.
You won’t, you are kind of resigning yourself to doing as well as the market does and overall,
president appearances perhaps not so confirming, overall the market goes up and you’ll benefit
but as I say, you’ll have to give up the illusion of being smarter than everybody else.
Douglas Goldstein: Tell us about your new book and how people can follow you and follow
the work that you are doing.
John Allen Paulos: A Numerate Life is my latest book.
It’s partly personal, partly mathematics, I use incidence from my life as jumping off
points to discuss mathematical notions that help us analyze all our lives not just mine
and I think it’s pretty good by the way and yet it’s available from Amazon and you
can follow me on Twitter @JohnAllenPaulos and my webpage is also www.johnallenpaulos.com.