Can an Economist be a Trader?

Fin_Indie asked for me discuss how I reconcile being an economics professor and an active trader. I assume he is thinking about the efficient markets hypothesis (EMH) that states that all known information is incorporated in stock prices and prices only move when new information is revealed. This is also often taken to imply that stock prices move according to a pure random walk and changes in prices are unpredictable. Some take this idea further arguing that investors should simply invest in a diversified buy and hold portfolio as there is no way to profit from trading or even deviating from a market weighting of securities.

There are two parts to my response. One is to explain what I think EMH really implies and second to question whether the strong version of EMH holds. As a good economist I don't believe in too many free lunches. Financial markets are highly competitive markets and there should not be easy ways to make above average risk-adjusted returns (taking on more risk is a simple way to get above average returns). Otherwise, participants should simply get a standard return for their provision of investment capital to the market. That is, if that is all they provide. I argue that other inputs provided by investors should also receive returns in this market. These include returns on skill, returns on effort (time spent investing), and returns on special information. Of course if you don't have any of these then don't try to beat the market... It defies imagination that say Warren Buffett's track record is the result of pure chance. Rather, his excess returns reflect returns to these additional inputs. If you think you have these additional inputs you might have an edge, which you can test statistically and then it will allow you to beat the market.

Of course it helps that I am not a professor in the field of finance. I don't even have a PhD in economics (but another field instead). I do have a BA in economics (and the other field) and some graduate classes. I have been published in economics journals, I am a professor in an economics department, and I obviously teach economics. But my background is interdisciplinary and I think makes me much more open to alternative ideas than I might be if I had been indoctrinated in mainstream finance theory in grad school. Most of my research has been empirical and uses time series analysis.

The second part is to argue that while EMH is a good benchmark the strong form of the hypothesis does not hold. Countless anomalies have been documented. The most obvious is that stock prices fluctuate far more than do earnings or interest rates, which are their supposed determinants. A major issue that prevents the market from being perfectly competitive is as I have blogged before most participants in the market do not short-sell and many have mandates to remain fully invested in equities whatever happens. Active traders and hedge funds remain a minority of the participants, despite being very active. Even in among the active traders few are directional traders. Most are arbitrageurs, market-makers etc. Therefore, some forms of technical analysis do work. This is not a "belief" of mine but something I have now tested in the statistically validated trading model I am using. A lot of technical analysis out there makes no sense and a lot of the publicly available TA won't produce excess returns. This is not surprising. But a little digging will produce some useful approaches. Still, most participants have been persuaded that TA is nonsense. That is their problem not mine.

Fin_Indie also asked about my philosophy and inspiration. My basic approach is to trade my account like a global macro hedge fund, with a fairly conservative approach to adjusting the market exposure of my investment portfolio and an aggressive TA approach to trading the trading account. My biggest inspiration on how to trade and invest has been George Soros. But I have drawn elements of what I now do from all over and testing what works and what doesn't. Robert Kiyosaki's books were a big inspiration too.