Finance Stuff They Teach You That’s Wrong

by nikiscevak on November 2, 2010

Over the past few years I have become a complete student of value investing and have been quite successful. So naturally when some dumb schmuck gets lucky, the desire to impart the ‘fool proof’ system rises.

But seriously, there are two huge principles of finance that they teach you at University that I think are completely wrong.

When buying, the price of a share does not matter (or the efficient market hypothesis). Academic study says that the market is efficient and therefore the price of a security fully captures all of the possible information. But there are obvious situations where this is completely wrong. When a stock is included in an index, funds that mimic the index then have to buy the stock. This has nothing to do with the underlying value of the stock.

Conversely, some institutional investors have preset limits on the size of companies they can invest in. If a stock falls below that threshold, they have to sell no matter what the future prospects of that company. And that’s just capturing the obvious situations: There are countless more that revolve around the themes of emotion, complexity of the security and the rules of market participants mean that the theory is completely full of shit. At least over shorter time periods. Benjamin Graham said it best: “Markets in the short term are voting machines but in the long term weighing machines”.

Risk is best measured by volatility. This one is completely baffling to me. Here the theory has it that the risk of a security should be measured by how volatile it is. If the shares of IBM go up by $50, the stock is just as risky as if the shares of IBM went down by $50. IBM at $100 is a lot less riskier than IBM at $200 but the concept of risk = volatility says that the risk is exactly the same in both situations.

This concept led to the creation of mortgage securities that were ‘safe’ because they didn’t move much in price. But still waters run deep and years of steady and safe-seeming trading blew up like a bomb upon the realization that everything was fundamentally flawed.

You can see the same trends appearing in the Government bonds of countries like Greece and Ireland a few years ago (everything is OK until it isn’t) and probably the very same thing happening with US treasuries at the present time. Still waters run deep.

  • Paul

    I agree 100%.... painfully, Planners and Brokers try to go down this path regularly.

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