How do we Minimize the Risk?

To delve a bit deeper first start with basic understanding of technical analysis & fundamental analysis. On the basis of their expertise in these theories, many fund houses over the world claim to beat the benchmarks. Let us understand the base assumptions behind formulation of these theories.

Assumptions:

1. Fundamental Analysis:

This theory states that every stock has its fundamental value based on companies performance. It assumes that at any given time stock may reflect any value higher or lower than its fundamental value but eventually it will meet its fundamental value in future. So by analyzing a fundamental strength of the company and picking prospects companies we can beat the market benchmarks.

2. Technical analysis:

Unlike fundamental analysis, which attempts to evaluate a security's value based on financial information such as sales and earnings, technical analysis focuses on price and volume to draw conclusions about future price movements. It has its origin from DOW Theory which was formed in 1800 and was based on following assumptions:

• The Dow Theory was developed in the late 1800s by Charles Dow and his business partner Edward Jones, who founded Dow Jones and Company.

• The market discounts everything: The price of a stock reflects all available information. 

• The market has three trends: At any given time, the market is influenced by three trends: primary, secondary, and minor. 

• Primary trends have three phases: The primary trend has three phases: accumulation, public participation, and distribution. 

• Averages must confirm each other: Trends in different market indices should confirm each other. 

• Volume confirms the trend: Volume should increase in the same direction as the trend. 

• A trend remains intact until it gives a definite reversal signal: Trends continue until a clear reversal signal is given. 

Technical analysis has its own set of assumptions:

• The market discounts everything. This means that everything that's important to a stock is already priced in. 

• Prices move in trends. This means that prices will follow trends, even in random market movements. 

• History tends to repeat itself. This means that price movements tend to repeat themselves, which is often attributed to predictable market psychology. 

Our fund management industry is completely based on above two theories either individually or in combined format. This industry claims the possibility of producing returns more than benchmark by selecting higher performing stocks and creating a portfolios with the help of above two theories. But here is an existence quite less known theory “Random Walk Theory”.  

Random Walk Theory:

• According to the random walk theory, the past movement or existing stock price trend cannot be used to predict its future direction (either upward or downward).

• Thus, the core message is that it’s impossible to beat the market consistently, so investment advisors add little or no value to an investor’s portfolio.

• Moreover, this theory questions the validity of using technical and fundamental analysis to trade or pick stocks for investing.

• It considers fundamental analysis undependable because of the low quality of data available and its potential to get manipulated.

• Likewise, it considers technical analysis unreliable because it results in the individuals following the charts and trading stock only ‘after’ a move has occurred. Most of the technical indicators are lagging in nature.

• Random walk theory is a practical tool and has proven correct in many cases. Thus, it suggests people not waste money hiring fund managers to handle their portfolios. If some fund managers could provide better returns than the broader market, it could be due to luck, and it’s tough to sustain in the long run.

Efficient Market hypothesis(EMH):

The Efficient Market Hypothesis (EMH) was formulated in the 1960s by economist Eugene Fama and introduced in his 1970 book, Efficient Capital Markets: A Review of Theory and Empirical Work. The EMH is a financial economics theory that states that asset prices reflect all available information, and it's difficult to consistently beat the stock market. It has considered three possible forms of market:

1. Strong form

The strong form is the ideal version of the efficient market theory. It follows the belief that all ‘public’ and ‘private’ information is already absorbed into the stock price. No extra information is available for the investor to gain an advantage in the market.

Advocates of this form believe that investors can’t exceed average market returns, regardless of information retrieved or research conducted. They claim that fundamental analysis, technical analysis, and investment advisory services are worthless. The best way to earn money from the market is to adopt the buy-and-hold strategy.

2. Semi-strong form (nearest to practical)

The semi-strong form suggests that the stock price reflects all ‘public’ information available to the market participants. Thus, retail investors can’t use either fundamental or technical analysis to gain higher returns in the market.

But those with access to private or insider information could outperform the market.

3. Weak form

Weak form believes that no historical data points affect the stock’s price. These data points include price, volume, earnings data, etc. 

Also, one can’t use past data to predict future value. In this case, no trader can gain an edge from technical analysis.

But, the weak form states that stock prices reflect the current information. Thus, the supporters of this form believe that one can determine undervalued or overvalued stocks only using fundamental analysis. Plus, they can increase the chance of making higher than market average profits by researching companies and financial statements.

Theoretical Conclusion:

All the theories mentioned here is based on certain assumptions which are yet not proven academically. But believers of Technical and fundamental analysis has produced PMS, Mutual Fund and Hedge Funds etc. While Random Walk Theory and Efficient Market Hypothesis(EMH) believers has produced ETFs or Index Funds.

It is evident from the data that 75% of mutual funds are unable to beat bench mark and more than 70% of the hedge funds fail within 2-5 years of their inception. Hit rate of this industry is quite low to prove the utilized theory, concretely.  And in the current state it is evident that theories, these people utilizing are based on certain assumption that are not proven yet with a high confidence rate, like more than 50%, even after application of Fundamental Analysis and Technical analysis by fund managers for over 200 years. Following fund manager’s success rate data is evident for the same:

The success rate of fund managers varies depending on the time period and the type of fund: 

• SPIVA – India report: On average 75% of mutual funds under perform their benchmarks  

• In 2023, active fund managers had a success rate of 46%, while foreign and fixed-income managers had a success rate of over 50%. 

• Over the past decade: On average, 27.1% of actively managed funds beat the S&P 500 each year. 

• Over the last 15 years: 88% of active large-cap funds failed to beat the S&P 500. 

• Over the last three years: About 80% of active large-cap funds failed to beat the S&P 500. 

Last but not the least, following picture shows the % of out-performing funds in last 1,5,10 and 20 years. The research has been done on the data received from S&P Dow Jones Indices LLP.

While on the other hand Random walk and EMH neither promise more nor they are delivering less. So, now after understanding above facts it is like taking a medicine, having a success rate of less than 20%, because there is no other possible remedy for the growing wealth. Which seems no less than trying your luck out in the markets and put a big question mark on methodologies utilized by fund managers to beat bench marks.

How this observation connects with wrong focus, wrong psychology and wrong risk assessment & management. Because these are the main reasons behind 99% cases of failure as a trader.

• Wrong Focus – This category problem is not a concern because this topic of discussion is for the people who see stock market as a business not as quick & easy money like lottery.

• Wrong Psychology – Psychology is a very subjective matter to discuss but this is research evident that the impact of latest trades being profit or loss on the nxt trade have a negative outcome on trader performance. This psychological trait does not align with the predictive psychology of technical and fundamental analysis but this trait is well aligned with random walk theory and EMH. Which produces contradiction between trading philosophy and trading psychology of fund manager utilizing technical and fundamental analysis.  

• Wrong assessment/management of risk - Also, technical and fundamental analysis system is limited in risk assessment because it solely rely on forecasting based on historical performance of market so their risk management system is limited to high probability predictions based on historical events and fails completely when there is some extreme event occurs in market. Which is the reason behind failure of 40% hedge fund .

But we come up with a unique solution which addresses the issues in all above theories.

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Unique Solution to the existing problem:

Theory of order & disorder -

Our theory of order & disorder  adapt following assumption from the existing theories:

1. Our first assumption is from EMH –

“ Market is semi-efficient”

2. Our second assumption is from Random Walk Theory –  

“ Market price change is random and prediction is not possible”

3. Our hypothesis –  

“We can beat markets”

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Our assumption 1 states that all public information is available to all so retail traders cannot have edge over market but some insiders having sensitive information can beat market. Our assumption no 2 is inline with assumption no 1 because market price is random except insider trade impact the prices. But any change in price due to the insider activity is also a subset of random outcomes from trader with public information point of view. Which derives that trader with public information and considering market movements as random does not need to be concerned about insider trades.

Our hypothesis states that even if markets are semi-efficient and market movements are random but still we can beat markets contradicts with existing random walk theory and EMH which states that we cannot beat markets in random situation and if market is semi-efficient. Also, if this hypothesis found to be true then it certainly puts up question mark on the existence and need of technical analysis & fundamental analysis for traders and fund managers who want to beat the markets.

So let us delve quite deeper into some statistical theories pertaining to the situation of random outcomes. And will try to prove how our assumption is true through which we can develop our understanding of how we can beat markets in random outcome scenarios.  

PROBABILITY OF OCCURANCE OF CERTAIN EVENT AFTER "N" EVENTS WHEN WE HAVE TWO RANDOM OUTCOME :

P(profit@N) = 1-P(loss)^N

N =[LOG1-(P(profit@N))]/LOG(P(L))

PROBABILITY OF OCCURANCE OF PROFIT = IST DAY IT IS 50%, SECOND DAY IS HALF OF FIRST DAY WHICH IS 25%

SO TO BE BREAKEVEN FOR GIVEN MAX AVG LOSS % AND MIN AVG PROFIT % N CAN BE FOUND OUT AS -  

LET INTIAL EQUITY BE "X"

THEN x*(1+avgprofit/100)^(N*P(p))*(1+avgloss/100)^(N*P(l)) = x can not be solved for n so hit n trial for calculating considering x = 100

seen from table heading cloloured yello,  requirement of profit against various losses

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but certainly two of them, technical analysis and fundamental analysis have created a world of fund managers. However, it is evident from the data that 75% of mutual funds are unable to beat bench mark and more than 70% of the hedge funds fail within 2-5 years of their inception. Hit rate of this industry quite low and the reason behind it is evident that theories these people utilizing are based on certain assumption that are not proven yet. So, it is like taking a medicine not yet qualified its testing criteria but this medicine is being utilized by some intellects who believes in it and making ill informed people to believe in it even after a failure rate of more than 70%. From my perspective it is not less than believing some super natural phenomena or a kind of blind faith or trying your luck because you have a no other option.

• HISTORY RHYMES ITSELF

• Key to understand future lies in the past. To understand this concept let us draw an analogy between Universe and Mathematics. With time universe is expanding and it began from nothing when energy and mass was single entity, as per big bang theory. Let us consider the beginning of universe as point zero and one side of expansion as positive leading to +infinity and other side of expansion as negative leading to -infinity. Now let us assume mathematical numbers also expanding with time, starting from zero towards +infinity and -infinity.

Now consider every event in universe is unique and represented by each number. As we all know that each number is unique and not repeatable but there are some properties which are repeatable like we can categorize them in odd, even and prime numbers. For even numbers we know that every even no is divisible by 2, for prime nos we know that it is not divisible by any no. Like this we have every no as unique but some properties are rhyming. Similarly, we can understand that every event in this universe is unique and not repeatable but rhyming. So, we can understand that history does not repeat itself but it rhymes itself. Similarly, stock market is always new but we still can find some repeatable properties pertaining to some patterns and can use them to take well informed and mathematically calculated decisions.