February 17, 2009
Secondly, our mathematics – which Dr. Edesess dismisses – was done jointly with Harry Markowitz and Jun Liu, as well as my colleague Jason Hsu. None of these is a slouch at math. Basically, we simply try to formalize the mathematics of a world in which there’s an invisible and unknown fair value, and price follows a mean-reverting random walk, always tending towards that fair value but with new shocks that keep the errors in price from disappearing. This sounds more like the “real world” to me – and to Harry Markowitz! – than the EMH world, in which price and fair value are the same, and shocks move both price and value identically.
- Our model predicts a size effect, a value effect, and long-horizon mean reversion in prices and valuation multiples. With pretty reasonable parameters, it actually predicts closely conforming to the evidence of the real world.
- Our model also predicts that the cap-weighted market will underperform a price-indifferent portfolio – a portfolio where our investment won’t be twice as large just because the price doubled – almost exactly in line with the observed performance drag.
- For what it’s worth, our model also says that 2008 shouldn’t have happened. But, it’s just a model. Like most models, it’s only an approximation of the real world. But, it’s a better model, in my view.
Finally, I noticed six instances in which Dr. Edesess changed my core assumptions or otherwise materially altered my arguments. There may be more. I will offer a bottle of excellent 1980s vintage Bordeaux to the each reader – including Dr. Edesess – who identifies each of these … or any that I missed. To protect my wine cellar, I’ll limit this offer to twelve bottles of wine. Have at it, folks!! [Ed. Note: Advisor Perspectives will, at your option, publish your winning entry.]
‘Nuff said. Dr. Edesess, over to you. If the mathematics of efficient markets are compelling to you, I’ll look forward to times when you’re on the other side of my trades! If you’re moved to offer a rebuttal to this rebuttal to your rebuttal to my first rebuttal, the gentle readers can rest assured that I will spare them any additional rounds. You may have the “last word,” if the inspiration moves you. All the best!
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