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Delos Chang

Why Investors Buy Low and Sell Low:

A Comparison between The Bear-ren Market-Timers and A-bull Buy-and-Holders

It is becoming more and more of popular opinion that the average investor today simply

cannot compete with the Wall Street “professionals”, who, as many argue, use sophisticated

analysis techniques and stock valuation beyond the typical investor’s comprehension to

determine which equity to invest in. Thus, from Wall Street arrive advanced stock derivative

formulas, the charting of trends, along with multitudes of other “professionalized” methods that

not only befuddle the ordinary stock investor but, allegedly, outright remove them from any

profitable competition. Yet, since the stock market is an efficient mechanism that only allows

consistent above average returns through consistent above average risk by reflecting all relevant

information in stock prices, no investor, professional or otherwise, can consistently time the

market accurately and reap above-average profits when compared to a simple buy-and-hold

strategy with a diversified portfolio following a broad stock index.

Before any further valuation of the nature of the stock market can be conducted, it is

imperative to realize how markets are efficient and how this definition relates to the efforts of

other valuation techniques which claim that the stock market can be exploited and timed for

profits because it is not efficient. The term “efficient” can be recognized through a short parable

explained by Princeton economist Burton Malkiel in which a young man eyeballs a loose $50

bill on the ground as he is walking. Before picking up the bill, the man reasons, “This is

obviously not a $50 bill. If it were genuinely a $50 bill, it wouldn’t be here in the first place!”

(Malkiel, 246). The proposed efficient stock market is not a market where $50 bills can be found

freely nor where the normal investor can readily pluck them from the branches of Wall Street

because stock prices are random walks in their movements and thus, unpredictable due to the
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efficient market. These random walks bear fundamental weight to the price movements of the

stock market and the impossibility of timing the market. Instead, the efficient market is

“efficient” because investors cannot find these $50 bills without investing in risk equivalent to

obtaining the $50 bill. Still, many investors claim that although there may not be any $50 bills

lying around, there is loose change for the ambitious investor without increasing risk. In short,

such stock investors claim that the market is not efficient and that there are reliable and

consistent ways to pick up such tangible $50 bills from the ground. From these investors arrive

different methods of stock valuation, all in the attempt to out-profit and outwit the questionably

efficient market. Yet, if the stock market’s nature operates efficiently, by definition, no above-

average returns can be made without above-average risk and no method can predict with

continuous accuracy the random walk of stock prices which are too easily affected by

unpredictable events to be foreseeable. Thus, these schemes of profitable stock valuation, when

tested in long-term horizons, will consistently fall short of the conventional experimental control

of the buy-and-hold strategy, which does nothing to predict the trends or challenge the efficiency

of the stock market. Thus, in order to seek an answer to the nature of the stock market, inefficient

or efficient, random or predictable, one must first test the tools of the commonplace “inefficient”

market proponent and the alleged evidence that he so readily offers.

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While the effort to determine just when to buy or sell a stock and thusly, how to time the

market, has spawned and spurned many methods and remains still one of the mysteries of Wall

Street, “[many investors] have come to accept either one of two theoretical premises which

challenge the trendless, efficient market theory, one of which is technical analysis: the study of

stock charts and trends in order to outmaneuver the masses for profit” (Lowenstein, 58).

Technical analysts or chartists conclude their decisions to buy or sell based on anticipation of the

masses’ decisions, another theory aptly named the castle-in-the-air theory. Proposed most

cogently by John Maynard Keynes in 1936, the castle-in-the-air theory opts to anticipate the
Figure 2 - Coin Flip Experiment: a false stock market trend occurring at
chance flips of a coin where a “heads” would equal an increase in closing
crowds of investors who
prices and a “tails” would equal a decrease in closing prices
Figure 1- The Classic "Head and Shoulders" Chart: a favorite tell-tale sign for the technical analyst indicating that the
market will drop below the established “market neckline”.

optimistically invest and build their hopes into castles in the air without any regard or

justification for a stock’s true value, the apotheosis of which would be the recent high-

technology, internet bubble in the early 2000s. As long as an investor can buy the stock at a low

price before the swarms of exuberance pull the prices up, the theory goes, profits can be realized

by selling high even if such evident stock prices cannot be justified by their intrinsic values. In

short, under the castle-in-the-air theory, one should buy a stock without regard for its true value

as long as one can be sure a greater fool will come in and buy the stock at a higher price. Thus,

the technical analyst exists, studying stock charts and trends in order to predict the next irrational

exuberance, the next castle in the air so as to outmaneuver the crowds and buy low at the

beginning before greater fools assign a higher value. The ordinary technical analyst views the

stock chart as the Bible of Wall Street, a holy grail reflecting all previous performance,

dividends, growth, price-earnings, and most importantly the actions and decisions of other

investors. Thus, to the technical analyst, the current stock prices, yields, and earnings are at best

inconsequential since all possible and relevant information would theoretically be incorporated
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into a stock chart. All that matters would be the stock chart itself, depicting the trends in the

market to follow and the supply-demand balance. At its most basic form, should an upward,

bullish (an upward stock price

disposition), trend appear on the

charts, technical analysts happily

buy in anticipation for the trend and

stock prices to continue moving up.

Furthermore, technical analysts

survey their charts religiously for

typical signs and symptoms of the

stock market like the classic “head and shoulders” formation which, when prices fall below the

neckline, signals the time to sell as depicted in Figure 1 (Malkiel 52). The rationale behind

charting follows closely behind the mass psychology appeal of the castle-in-the-air theory in that

people who see stock prices climb higher will generally jump on the bandwagon, thus causing

more people to buy into the stock and into a positive feedback loop.

Despite such justifications, technical charting proves still invariably flawed when tested

against the random-walk, efficient market theory. The principle idea behind charting provides

that a definite relationship exists between the prices of the past markets and the prices of the

current market. In such a world, stock prices are further likened to roller coasters, carrying long-

term momentum in their trends so that an upward trend yesterday would increase the likelihood

of an upward trend today. A series of tests relating past and current market trends and prices

administered by Amsterdam economist Gerwin Griffioen “[proves] that the charter’s hypothesis

simply is not true and that the correlation between today’s and tomorrow’s prices would be

minimal and economically insignificant, much less profitable” (Lowenstein, 60). In Griffioen’s
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test, the market prices were measured against future market prices in an attempt to realize any

noticeable correlation, the result of which divulged little statistical significance. Furthermore, the

alleged patterns in “stock charts are, at best, statistical illusions of a trendless market” as first

supported by the efficient, random-walk, market hypothesis (Griffioen 1). The evidence of a

trend subsists, at best, due to the

runs of fortune, not unlike the

chanced results of a fair gamble. To

illustrate, the following hypothetical

stock chart was elicited through a

coin-toss experiment done by economist Malkiel in Microsoft Excel where the closing day price

was decided by a coin toss (Malkiel, 130). If the result of the coin toss was heads, the closing

price would be ½ points higher and if tails, ½ points lower. Evidently, although the chart

represents no more than the plotting of insignificant chance results, its pattern depicts a “head

and shoulders” trend as discussed before, an allegedly key signal for the chartist to determine the

time to sell. Indeed, the typical chartist tells of an upward trend would be no more than a

sequence of “heads” and a downward trend a sequence of “tails”. This unpredictable nature of

stock prices produced by a random process similar to the coin toss is labeled a random-walk,

aptly characterizing the random-walk, efficient market hypothesis. Furthermore even if charting

bore statistical significance and predictable correlation to the next market prices, the applicability

of technical analyzing would often be disrupted since the ordinary chartist must invariably time a

buy or a sell with accuracy and abrupt turnarounds in the market combined with the transaction

costs and brokerage fees would negate any possible profits and dip into losses. Ultimately,

although the greater fools building castles in the air theory may be sound in principle, the

technical analyst cannot time the market with trends and charts because the market moves in a
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random walk like a coin flip, fifty-fifty with little significant memory and relation to past events.
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The other generally accepted tool to predict when to buy or sell or how to time the market

is fundamental analysis, the study of past income statements, balance sheets, price earnings ratio,

and general company history in order to determine a stock’s true value and to buy or sell against

it. Indeed, contrary to the chartists, the fundamentalists “subscribe to the firm foundation value

of theory, claiming that the market is more logical than psychological” and that one should

calculate the investment instrument’s intrinsic value and future forecasts to sell if current prices

are above such value or to buy if prices are below such value (Zimmerman, par. 2). In both

situations, the typical fundamentalist measures such anchored values as determined by a

multitude of factors, all of which are directly identifiable and useful in market timing for profit.

Touted by S. Eliot Guild and John B. Williams in his The Theory of Investment Value, the firm-

foundation theory further claims that based on a company’s current earnings and ability to

distribute dividend income, the stock’s intrinsic value should accommodate accordingly, “rising

with increases in growth rate and dividend payments” (Williams, 214-217). Ideally, the

fundamentalist should buy if the market price is below that of calculated intrinsic value and sell

if the market price is above said value. Many methods have been postulated in order to estimate a

security’s worth but commonly, “fundamentalists rely on the P/E ratio”, a calculation with the

earnings per share and thus dollar amount per share an investor is willing to pay, to indicate

distinctions in possible long-term growth probabilities (Zimmerman, par 6.). Logically, an

investor would be willing to pay more for a better yield. The firm foundation theory formulates

future projections of long-term earnings and expected growth rates, estimating a security’s worth

years into the future and thus, challenging the random-walk, efficient market hypothesis which

states that stock prices are too volatile and influenced by unpredictable events to be foreseeable.
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Despite the unmistakable logic behind the fundamentalist mindset, several flaws reduce

the efficiency of accurate future prospects and indeed, the track record of such fundamentalist

mutual funds who seek to time and predict the market often end up supporting the efficient

market hypothesis instead where stock prices are unpredictable. Several findings led by Sudhir

Milkrishnamurthi of MIT and Michael Sandretto from Harvard illustrate the inaccuracy in stock

price forecasting. Information of both short-term one-year forecasts and long-term projections

were collected from numerous professional fundamentalists on the future stock prices of the

primary companies in the S&P 500 (Miland, par. 3). The results were harrowingly clear: in every

industry, Wall Street’s professional analysts miscalculated, providing obvious error rates that

proved remarkably constant. Furthermore, studies from Joseph Abbott and I/B/E/S, a tracker of

Wall Street’s top analyst’s research reports and expected corporate earnings, corroborate with

Sandretto and Milkrishnamurthi’s findings with S&P 500 companies “outperforming analyst

forecasts 50.4% of the time over 19 years, falling short of earning projections 37.7% in the same

period, and validating financial estimates only 11.9% of the time” (Abbott, 3). Such

“professional” analyst calculations amounted little more than conjecture as Princeton surveyor

Burton Malkiel demonstrated that many top-dog analysts following the latest hyped companies

failed to anticipate earnings better than a simple extrapolation comparison of past economic

trends and expansion in the national economy (Malkiel, 154). The difficulty of financial

fortunetelling arises with a random-walk market, assimilating unpredictable random events into

corporate earnings and thus stock prices. The unpredictability of U.S. regulation and

deregulation, international incidents, natural disasters, terrorism, new innovations and

competition, monopolies, inflation, changing exchange rates and management affairs each could

drag individual corporate finances one way or another. The sheer influence of arbitrary events

holds great sway over any company’s earnings, posing an obstacle to technical and fundamental
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analysts who seek to time the market based on calculations and charts. Thus, the random-walk

market exists, eluding formulas and charts because its pricings are too influenced and fickle to

consistently foresee.
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Ultimately, the most zealous of fundamentalists and technical analysts champion market

timing, buying and selling stocks at specific times in market periods for profit, a method that

falls short in efficacy compared to a buy-and-hold strategy with a diversified portfolio in a wide

stock market index. Indeed, in every market cycle, a market timer such as a fundamentalist or

technical mutual-fund professional would need to reliably predict sudden market turnovers

before stock prices take a dip in market value. Along with the previous demonstrations of both

fundamentalist and technical inaccuracy, historically escalating stock prices in thirty-six years

and falling markets in fifteen years over the past fifty-four years, to the market timer, “the

Figure 3: S&P Index Growth: a proof of historical chances of forecasting accuracy works
success in a buy-and-hold strategy in a broad index
fund. three to one against [the investor]”

(Malkiel, 214). Furthermore, historically, under a buy-and-hold in a broad-based index strategy,

the capital gains in equity resulting from a rising market would largely compensate any capital

losses from a falling market because of the slow but progressive national growth and GDP as

shown in Figure 3 from the Wall Street Journal and Haver Analytics showing the 10-year, 15-

year, and 20-year averages (Altig, 3). Evidently, a buy-and-hold strategy following the S&P 500

Index for a period of forty years would have yielded a very profitable return in terms of more

time available from not attempting to time the market, capital gains from selling the securities,

and reduced tax from the long-term capital gains tax which provides a lower rate of 5%-15%

(depending on the investor’s marginal tax rate) compared to the short-term capital gains tax of up
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to 35%. Meanwhile, the daredevil

market timer must compensate also

for transaction costs and discount

brokerage fees and short-term capital

gains tax from any profits. Thus, the

random-walk, efficient nature of the

stock market thwarts attempts at a

consistent forecast of where the ever

elusive free $50 bill might be.

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Unlike technical charting or fundamentalist formulations, the random-walk, efficient

market hypothesis acknowledges the impossibility of market timing due to the fickle, influenced,

unpredictable nature of stock prices. Price movements adjust with little memory of past

movements, reflecting new unpredictable information into the market that a market timer simply

cannot accurately and continually predict as empirically evident from the coin-flip test,

debunking of the technical analysis. Indeed, such a market is erratically priced rather than

systematically as proposed by the trend-loving chartists and unpredictably affected by random

events rather than anchored by intrinsic value as suggested by the fundamentalists. Ultimately, to

obtain above average returns in equities, one must indulge in above average risk that others

would regularly pass for average return. Otherwise, through sheer logic, without above average

risk to obtain above average return, so many undeterred investors would flock to acquire above

average return at easily average risk that the higher return would be self-defeating and ultimately,

become the new average yield. In short, the buy-and-hold investor following the index receives a

maximum average return that technical and fundamentalist market timers cannot consistently

beat. As such, the random-walk, efficient market hypothesis proposes not market timing but a

conventional buy-and-hold strategy to afford the net capital gains during periods of rising and

declining markets with profits paralleling the rise in historically consistent rise in national

growth. Such a buy-and-hold strategy can be variably adjusted for increased risk for potentially

higher yield and diversified to reduce unsystematic risk by offsetting capital losses with capital

gains in a managed portfolio with stocks spread in different industries. Thus, although the above-

average return, free $50 bill might not be within reach, a simple diversified portfolio attains the

next best available option of persistent average return in a random, efficient market.
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Bibliography

1. Abbott, Joseph. Corporate earnings outlook - consensus forecasts. Graceway Publishing

Company Inc, 1991.

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<http://users.rcn.com/virtual.nai/sot/j11.html>.

3. Altig, David. "The end of buy and hold?" Economic Research and Data.

4. Fontanills, George A. The Stock Market Course. Wiley, 2001.

5. Griffioen, Gerwin. "Technical Analysis in Financial Markets ." Social Science Research

Network. 2003. 24 Feb. 2009

<http://papers.ssrn.com/sol3/papers.cfm?abstract_id=566882>.
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6. Jones, Charles P., and Robert H. Litzenberger. "Quarterly earnings reports and

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Works Cited Page

1. Abbott, Joseph. Corporate earnings outlook - consensus forecasts. Graceway Publishing

Company Inc, 1991.

2. Altig, David. "The end of buy and hold?" Economic Research and Data.

3. Griffioen, Gerwin. "Technical Analysis in Financial Markets ." Social Science Research

Network. 2003. 24 Feb. 2009

<http://papers.ssrn.com/sol3/papers.cfm?abstract_id=566882>.

4. Lowenstein, Roger. When Genius Failed: The Rise and Fall of Long-Term Capital

Management. Random House Trade Paperbacks, 2001.

5. Malkiel, Burton G. A Random Walk Down Wall Street (Revised and Updated): The

Time-Tested Strategy to Investing. W.W. Norton & Co, 2007.

6. Miland, Marius. "Why good earnings aren't enough." Forbes Magazine.

7. Williams, John B. The Theory of Investment Value. Fraser Publishing Co, 1997. 214-17.
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8. Zimmerman, Shannon. "The Death of Fundamental Analysis." The Motley Fool. 2009.

28 Feb. 2009 <http://www.fool.com/investing/general/2009/02/11/the-death-of-

fundamental- analysis.aspx>.