Investment Game 2016: Efficient Markets and Strategic Considerations

Dear participants,

With the Investment Game underway, we thought it is the right time to provide you with some general insight and strategies that we believe might be useful to employ in this competition. The thing that makes this competition different from real world trading is the limited amount of time over which trading occurs. While in real world trading may occur at different time intervals, from microseconds in high-speed trading to years in private equity, most money managers will have to consider monthly, if not yearly horizons for their investments.  When the relevant horizon is much shorter than years, which it is in the case of this game, selecting your investments might become a little harder. The reason for this is simple and is directly related to the concept of market efficiency.

All of the trading that we do can be broadly split into two parts: getting the betas and chasing the alphas. For those of you not familiar with the theory of portfolio choice: we are either trying to replicate what the market does and possibly under- or over-perform it by taking more or less risk, or we can hope to find the assets that will provide us with higher (abnormal) returns for the same level of risk. The investors who pursue the former strategy are commonly called passive, while those who try to benefit from the latter one are called active.

In the Investment Game, you can follow either of the two strategies as well. You can either buy the market portfolio (which could be roughly thought of as a market index, e.g. S&P 500) and hold it for the entire trading period, and get your respective rate of return. Since the competition lasts for just a bit more than 3 weeks, however, the return that you will get over this period will vary significantly depending on a multitude of factors.

Alternatively, as most of you probably will do, you can choose the path of an active manager. Here, you will be trying to cherry-pick the stocks or other instruments that you believe will under- or over-perform the market and profit from your knowledge (by either going long or short, or perhaps using derivatives). This aspect constitutes the virtue of active money management (for which some managers charge pretty handsome fees).

What you might go and do at this point is try to find a company that has an earnings announcement in 2 weeks and whose earnings are expected to increase by 18% (using analysts’ consensus). However, here is where the concept of market efficiency also steps in. If we believe that the markets are efficient, all the relevant information (including that produced by analysts) has been priced in. Hence, the market already knows that earnings will rise and nothing will happen to the stock price if earnings rise precisely by 18%. So how can you profit then? Well, you can make an abnormal profit that is not purely driven by the fact that you are lucky if and only if there are some deviations from the strong form of market efficiency. If, for instance, analysts are wrong in predicting the 18% increase and the true increase (relying on all public and non-public information) should be 24%, you may profit from buying that stock! Alternatively, if analysts are correct in predicting the 18% increase but for some reason the market prices experience only a 14% run-up, you can again profit from going long that stock.

Here is where your fundamental analysis steps in. If you invest resources in information (which is not free, your time has value!), you can outperform the market if and only if prices are not absolutely efficient. Now we will go back to the claim that we made in the introduction: why should it be more difficult to profit using fundamental analysis in the short run (3 weeks), than over a longer horizon (6 months)? To understand this, let us rephrase what you are essentially betting on using fundamental analysis: you are hoping that the market price is for some reason different from the “true” price that an asset should have. If, for example, the true price is higher than the market price of an asset, you go long that asset, hoping that its price will increase to its fundamental value. This convergence, however, is far from certain! There might be some market forces (short-selling constraints, limits of arbitrage) that will prevent that from happening before you have to close your position. There is even a possibility that prices will move against you, forcing you to close the position at a loss! When your trading horizon is just 3 weeks, what are the chances that the mispricing will be eliminated in that short time period? This naturally depends on the reason why the mispricing occurred in the first place. If the forces that created the mispricing are expected to persist, there are no rational grounds for expecting prices to drift back to fundamental levels – rather they may linger around their present levels or even move against you under the influence of other market factors.

That is why events are so important in short term analysis. By removing uncertainty, events forcefully push prices back (or closer) to their fundamental levels, but only if investors’ attitude to those events is incorrect or is not fully reflected in the current prices. In summary, we urge you to think what drives your potential profits in a chosen strategy. As illustrated in this article, doing so will often help you understand where the actual value can be potentially coming from, and will thus help you tailor your strategy in the best way possible. On a strategic note, we recommend using events as the harbingers of potential profit opportunities that you may exploit with your short term strategies in this competition. In a nutshell, whenever you press a “buy” or “sell” button, remember to always think why you might be more knowledgeable than the market!

We sincerely wish you good luck, and may the best man win!