A random walk is a mathematical experiment that describes a path that consists of a succession of random steps on some mathematical space.
During my first year working on JP Morgan’s investment banking team in New York, fresh out of college, I was dazzled by Wall Street. My group’s floor was always bustling with activity. It was early 1999 and the public equity markets were hot. Senior and junior bankers, in ironed shirts and ties, were busy preparing memos and presentations for IPO, M&A, High-yield, and syndicated finance deals. The bank was on track to have another record year and it felt like it was going to last forever as the economy diverged from the old days, we were in an era of the new economy.
Then came the 2000 crash. Many investors got burned by the dotcom bubble bursting and what was most strange to me was that no one was able to see it coming, even the top-ranked investment analysts. After the decline began, there were a number of pundits who were given plenty of airtime, claiming the market correction was inevitable, eloquently paraphrasing Alan Greenspan’s remark blaming the markets for “irrational exuberance”. However, I clearly remember hearing these statements after the market made the correction, not before.
A few years later, I moved on from Wall Street to Main street. With my interests in the markets still unabated, I followed the news, diligently read the Wall Street Journal, and pored through different analyst’s reports. Then in 2006, I decided to run an experiment.
I built a portfolio of stocks based on my research, cross-checking my portfolio holdings with major wall street analysts’ recommendations. Separately, I opened a brokerage account, picked a diversified investment portfolio of indexed funds by clicking on a few options based on my age, earning profile, and investment style. The purpose of the experiment was to find out, whether I, with the help of Wall Street’s brightest, am able to select winners and outperform the sleepy and unexcited index/mutual fund-based portfolio in my brokerage account. I ran the experiment for eight years, from 2006 to 2014.
The result was unequivocal and painful at the same time. While my hand-picked stocks were down 35%, my diversified index driven portfolio was up 29%. This was also when I decided that I would focus on my day job and trust the professionals to figure out my investment strategy.
What became apparent to me with the rise of high growth companies staying private for longer, is that I needed more exposure to the private securities markets. I opened an account with one of the top global investment banks and had their professionals recommend and buy selected structured products and make investments in private securities on my behalf. After maintaining that account for about 10 years, I realized a roughly 20% return net of fees, significant fees. I could have done much better had I simply invested passively in the public market. Obviously, the strategy of relying on professionals alone did not work, at least not for me.
All the while, the financial press kept publishing stories about visionary fund managers, with unique and guarded trading strategies that generated huge returns for their investors. However, I noticed that the names of most of these managers were different each year.
I decided to look for evidence of consistent market outperformance. I thought there should be giants of the industry, who consistently outperform the market. Those who through rigorous statistical analysis, analytics, and market experience can predict big market trends and events. I researched the history of market trends from the late 1960s when performance investing took hold. I studied cycles and trends from so-called “concept stocks” in the 60s, “Nifty Fifty” during the 70s, biotechnology and microelectronics stocks in the 80s, followed by the dotcom boom and bust of the ’90s, the 08 crash, and the social and consumer tech mania of the 2000s, which is still continuing to this day.
What I noticed was that during each one of these episodes, sophisticated investors, fund and endowment managers, investment advisors, and financial analysts, the elite performers who were heralded at the time as thought leaders, almost always performed with the crowds and were a part of the “exuberance”.
It occurred to me that there is something in human psychology that governs our behavior, making us less objective, prone to biases, and overconfidence, especially if achieving some degree of success. The “hot hand” fallacy is exactly that!
The “hot hand” makes us believe that others are right because they have achieved certain milestones in the past. This leads us to conclude that whatever played out in favor of a decision was achieved because that decision was predicated on future events.
This is similar to how Nassim Taleb describes The Narrative Fallacy in his book, The Black Swan:
The narrative fallacy addresses our limited ability to look at sequences of facts without weaving an explanation into them, or, equivalently, forcing a logical link, an arrow of relationship upon them. Explanations bind facts together. They make them all the more easily remembered; they help them make more sense. Where this propensity can go wrong is when it increases our impression of understanding.
This commonly shared belief still drives industry, news, public discourse, numerous TV shows, and conferences. We, the public, continue to believe the narrative that there are those who possess the ability to predict future trends.
According to renowned psychologist and 2002 laureate of the Nobel Prize in Economics, Dan Kahneman, if we define skill as something that consistently allows individual differences in performance, then fifty years of fund manager performance research shows that there is a minor correlation between year over year results. Meaning that investment performance is mostly related to luck.
A random walk is a mathematical experiment that describes a path that consists of a succession of random steps on some mathematical space. The Random Walk demonstrates our inability to lift the curtain of time to see the future. It also indicates that reliance on statistical tools only adds to our lack of sight. This is true because of one very simple reason, statistical data can look only backward. The most impactful events, for example, the current COVID 19 pandemic, will remain unique and unpredictable through statistical analysis.
What that means is that technical or fundamental analysis, with an abundance of formulas using all of the Greek letters, simply cannot predict the future. No one and nothing can!
To invest and build a resilient portfolio, diversification seems to be the best tried and true tool. An investor would do well if they are able to preserve and grow capital while also having some exposure to high beta opportunities. We all want to be the early investors of FANGs and other groundbreaking technologies of the future. Of course, the above assumes everyone has the same information and can act on it, i.e. that markets are accessible and efficient.
However, not all markets are efficient, and in some markets, certain privileged individuals may have more information, access, and ability to transact while others do not. This issue is especially prevalent in private securities markets, which despite the emergence of new technology, remains opaque and prone to network biases.
I do not want to spend too long discussing the inefficiencies in the private securities markets. In my view, the biggest challenges are that the market remains highly fragmented, and it is difficult for efficient price discovery to occur because most capital flows through a limited number of channels.
Despite its challenges and inefficiencies, there are still considerable investment opportunities available in private securities markets. These opportunities are not only available in Silicon Valley but are also prevalent in other parts of the country. Especially in areas where traditional industries can benefit from the development of nanotechnology, new metals, manufacturing repatriation, and other evolving trends in the economy.
That is why we believe that the time to build a more efficient and balanced private market is now. A market that has broad accessibility and low transaction cost to make building a diversified portfolio affordable, and that utilizes technology to be able to efficiently scale-up and grow to support the market as it needs to.
It is our single objective at iownit – to build a modern private securities market where investment opportunities are accessible leading to a reduction of cost of capital for entrepreneurs, and the cost of transacting for investors irrespective of their location.