In the last few posts I’ve been going on about how a lot of people think that financial markets are completely random because someone in academia at some point made a huge oversimplification. They did that because they needed some model for some abstract concept, and didn’t have anything better available.
It’s OK to simplify in a lot of cases, but we can’t be so naïve as to think that this is the truth, with no further need to develop better models. I’ve shown that with simple changes to the definition we can make technical analysis a viable approach. In this post I’ll go into some detail about what assumption we need to reality check for fundamental analysis to work in the context of efficient-market hypothesis and random walks.
So what is fundamental analysis, boiled down to maths, anyway? In simple terms it’s the current value of an asset represented by summing all future cash flows, with any future cash discounted according to some discount rate.
So far, so good. But what are these future cash flows, and what discount rate should we be using? This is where subjectivity enters the picture. Because, as these are all future events, your opinion is as good as my opinion really. Sure, you might have a better, or more educated guess, than me. But it’s still a guess.
This is all fine. Discussing and having opinions about what potential a company holds, that’s all good. We’d simply end up at a different target price for the stock, making us do different investments with regards to that asset in our own portfolios.
So far we are not in breach of any efficient-market hypothesis, because if we both did our analysis and we both acted on that together, the price would reflect both of our opinion through our market actions, and that would be it. That’s assuming we together represent the full market, and we always conclude at exactly the same point in time. On the random walk model we’d observe this as unpredictable jumps in the drift.
That’s a bit of a stretch, isn’t it? To assume that everyone takes all available information about some asset, looks at it, concludes, to then act upon that together at the same instant?
The world doesn’t work like that. It’s another simplification taken too far. We need to realize that people will take on board information at a different pace, and people will selectively pick what information fits better with their point of view anyway. It’s all a guess right, so we might as well align our guess with our values?
When we build a view of some value potential, we’re going to act upon this in the context of being influenced by whomever and whatever we surround ourselves with. It’s another one of those positive feedback loops, where there’s an ever changing mood around what fair value currently is at.
Fundamental analysis shouldn’t be an ego trip
It should be clear from the above that we should be allowed to assume there are delays in the view of what intrinsic value investors will put on an asset. That is a criteria for making fundamental analysis worth while at all. It means you should be able to take a view, and if you’re right, you’ll gain from that. You’ll gain from it because others eventually reach the same conclusion.
But what does being right imply? I think here there’s room to include a lot more than just looking at the asset in isolation. Because even if you could argue that you are right in your assessment of some asset value, if no one else agree with you, you’re going to be wrong.
Maybe over time others will eventually change their view towards that of yours, but can you afford to wait that long?
Incorporate this however you’d like, either as some future value bonus or future discount factor risk, but the mood of the masses must to be included. And with that, what might be a good investment opportunity in isolation, isn’t.