9

Profiting from Overreaction

Ongoing research in the financial academic community may directly support the wisdom of formula strategies in general, especially contrarian formula strategies like value averaging. The bottom line of this research, in layperson's terms, is that prices in financial markets possibly overreact.

TIRING OF A RANDOM WALK

This unimposing and seemingly innocuous observation packs an enormous punch if in fact it is true. It flies in the face of earlier theories that stock market and other financial market prices follow a random walk. Basically, the random walk hypothesis states that a series or daily, monthly, or annual rates of return on the market are uncorrelated, much like the sequential outcomes of the flip of a coin or the roll of the dice. That is, what happened today really tells you nothing about what will happen in tomorrow's market. Although this efficient market1 view is far from being accepted universally in the investment community, few have quarreled with its main precepts: New information affecting stocks is readily and efficiently reflected in prices; higher returns come at the cost of higher risk; and past results can't predict future performance.2

Kenneth R. French, who has done much research with Eugene Fama on stock price movements, notes: “Until recently, most financial economists agreed that stock returns are essentially unpredictable.”3 In the late 1980s, much evidence was analyzed to shed a different light on the movements of prices ...

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