A Mathematician Plays The Stock Market

Rating:
Summary: A Sucker Plays the Stock Market
Review: I do not plan on going gentle on this book, so if you are fond of the book or the author, you needn't read any farther.

My first complaint about this book is it implies that mathematicians, by virtue of their chosen profession, are all world class fools when it comes to investing. Surely Mr. Paulos is outstanding in that regard, and he has no business blaming mathematics or anything other than his own lack of character for his stock market fiasco.

Time was, if you did something shameful or grossly stupid, you suffered sociatal approbation. Mr. Paulos, in keeping with current ethos, chose to write a book about it.

Mr. Paulos regals his readers with how he managed his investments, which is a chronocol of almost every mistake a person could make:
$he bought at the top
$he did'nt put in a stop-loss order
$he used margins to increase his investment
$he willfully ignored all signals that something was wrong
$he threw good money after bad
$he was unlucky to have chosen Worldcom in the first place

Interspersed with this confessional is a lot of mathematically oriented stories which illustrate the counter-intuitive nature of probability. If you are interested in the psychology of investing, I highly recommend "Why Smart People Make Big Money Mistakes" by Blesky.

Perhaps the silliest thing about this book is that Paulos does not even entertain the possibility that it is theoreticlly possible to beat the market. It seems obvisous that if some people (such as Mr. Paulos) have above average losses, somebody somewhere has to have above average gains. Mr. Paulos, who is obviously highly intellegent, seems unable to make this observation.

This book is a two hundred page affirmation of what anybody who ever went to high school already knows: the smartest kids in the class often lack common sense.

Rating:
Summary: Of Numbers, Odds, Emotions and Crooks!
Review: If you would like an objective view of the stock market, are comfortable with math and enjoy a little irreverence in your investment reading, you will love this book. The material is easily accessible for anyone who finds algebra not too taxing. Professor Paulos minimizes the formulas for you by using anecdotes, simple brain teasers and practical examples instead.

What makes the book delightful is his self-effacing sense of humor. I cannot remember reading another book in which a writer is as candid and funny about his own failings as an investor. Only Andy Tobias comes anywhere close. The book's running joke is the professor's disastrous obsession with buying WorldCom stock using borrowed money before it became apparent that the company's reported earnings had more to do with wishful thinking than reality. It is this example that makes the book also insightful for the reader because it shows how easily our emotions and instincts can lead us astray, even when we understand as much about the stock market as Professor Paulos does.

I have read dozens of stock market books that have attempted to explain the "numbers" aspect of stock-market investing. None of them covered as much ground or did so as succinctly as this book does. I was very impressed by the depth of reading that this book reflects. Although it is not an academic book, the rigor is impressive.

The basic point is that the stock market is a lot more complicated than anyone can hope to understand, and likely to be more volatile than almost anyone will be comfortable with. Professor Paulos provides potential remedies for both (index investing, diversifying active portfolios, and using derivatives as insurance against large risks).

One of the many brilliant math examples shows how some games cannot be won with "success" strategies, but if you can combine a certain two "failure" strategies you will be a guaranteed success. With that wonderful point, the idea of being a contrarian was better expressed than in anything else I have read on the subject.

By inserting himself in the book through the WorldCom example, Professor Paulos powerfully introduces the element of individual and market psychology. Although he is neither a psychiatrist nor a psychologist, the book abounds with material about the psychology of how the market works and why investors make mistakes. To me, the ultimate lesson here was that one's stock market approach has to be one that fits emotionally well . . . or you will never execute it successfully.

Ultimately, successful active investing requires you to correctly pick what everyone else will find irresistible not too long before that compulsion hits them. I came away, once again, delighted that index fund investing is available as a sure-fired way to outperform more than 90 percent of all professional portfolio managers while sleeping soundly at night.

After you finish enjoying the book, I suggest that you also think about where else you commit your financial resources in large measure more due to your emotions than to your sense of how to calculate an advantage. How could you change your approach in that other area to be more emotionally and financially rewarding?

Donald Mitchell
Co-author of The 2,000 Percent Solution, The Irresistible Growth Enterprise and The Ultimate Competitive Advantage

Rating:
Summary: Excellent and realistic investment book.
Review: This is an excellent book on investment theory. It reviews fundamental analysis, technical analysis, option theory and many other topics. The author explains exceptionally well the Efficient Market Hypothesis and the debate surrounding it. He also introduces basic concepts of behavioral finance.
Abstract.

As a mathematician having studied the stock market, he believes the stock market is pretty efficient; and that both technical analysis and fundamental analysis do not have much predictive value.

Technical analysis according to him should be renamed trend analysis, as it consists in graphing and extrapolating current stock price trends. He covers the major strategies technical analysts use such as buying stocks when their current price breaks through its moving average, and selling them when they fall under this same moving average.

He covers fundamental analysis and their associated metrics in good details. Reading this section, you will become familiar with all the usual metrics, including P/E, PEG, P/Book value, P/Sales.

Mr. Paulos makes a case that the stock market captures the aggregate of all our psychological foibles, and goes on giving a good introduction in behavioral finance. He illustrates the common psychological flaws associated with investor behavior, including: the confirmation bias, anchoring effect, status quo bias, endowment effect, and Richard Thaler's mental accounts. He also illustrates flaws we incur when doing investment research, such as: data mining back testing, and the survivor bias. But, in aggregate these human errors partly cancel themselves out rendering the stock market pretty efficient.

The book's gem is the debate on the Efficient Market Hypothesis (EMH). The fewer the investors believe in EMH, the more they will engage in technical and fundamental analysis to extract excess return above the index. These "active" investors will render the market increasingly efficient, and negate their opportunities to earn excess return. The opposite is also true. If investors believe in EMH, they will become "passive" and just buy the stock index through a Vanguard fund or an ETF. As a result, the market will not be so efficient, and the EMH will not hold up in such a situation. So if you believe in EMH, it is false. But, if you don't believe in it, it is valid.

Paulos argues that enough active investors do not believe in the EMH to render it valid. This argument is convincing when you think of the thousands of mutual funds, hedge funds, and private managers on Wall Street. Thus, there are plenty of professional active investors to render the market very efficient. But, Paulos does not deny that certain markets at certain times, temporarily ignored by Wall Street, may be less than efficient. Thus, for him the EMH debate is not just a true or false question, it is a matter of degree.

Active investors play a crucial role in making the market efficient. Paulos makes an interesting distinction between the technical analyst and fundamental analyst. He states that technical analysts are momentum investors. Thus, they cause market volatility to increase. When stock prices increase, these guys buy even more. When stock prices decrease, they sell. Thus, they accentuate the swings in stock movements. Notice that they break the rule of Buy Low Sell High. The fundamental analysts are really value investors or contrarians. They do just the opposite of the technical analysts, and cause stock price movements to moderate. Thus, the two types of analysts/investors play a different role. But, together their active analysis make the stock market very efficient. The EMH states that all information is disseminated and absorbed immediately within the investment community, and thus is fully reflected within stock prices. But, somebody has to process this information. And, that is what the technical and fundamental analysts do.

One of Paulos other big concept concerns the statistical distribution of stock price movements. According to the EMH, stock price movements are random. And, this is true as confirmed by the autocorrelation on any time series of stock prices that is typically very close to zero. If stock prices move randomly, they should assume a normal distribution. But, Paulos indicates it is not always the case. In other words, extreme events (stock crashes or booms) happen more frequently than in a normal distribution. He adds that at the tails, the price movement of stocks is better captured by the power laws. Check page 178 for a detailed explanation on power laws. This is fascinating, and it may represent an upgrade to the EMH that relies solely on the normal distribution.