That's really an argument for buying index funds, since the costs and fees of buying and selling random stocks would eat away any profits very quickly.

(Even just buying and holding truly random stocks is still less likely to be a better investment strategy than index funds after taxes and fees are taken into account, let alone the volatility).

Sorry, I think I wrote hedge fund when I meant index fund. To clarify I've just replaced it with "valuation-weighed investment".

What about a random fund? Is there such a thing out there?

That strategy only makes sense for markets that are close to "informationally efficient", e.g., the public stock market.

I don't get it. The strategy involves throwing darts at randomly sorted stock listings. It uses absolutely no information other than the fact that the company is public. It actually implies that information is harmful. It's vulnerable to people setting up lot's of companies to win the investment lottery, so everyone can't do it, but otherwise I don't get what you mean.

So the idea is that in an efficient market, all the information in the market is already factored into the actual price of the stock. If the market has rich information, then it's very good at telling you what companies are good, but that doesn't help you actually invest in them -- because that information is already in the price of the stock.

In other words, when you're buying a stock, you don't actually care about whether the company is in an absolute sense good or bad, you care about whether it's relatively better or worse than what other investors think it is. In a perfectly efficient market, the answer is basically that it's always exactly as good as other investors think it is. Then your returns are based on random unpredictable shocks and the total trend of the market.

In a truly perfect market, it wouldn't matter what you invested in -- everything would have the same return. Your only real choice would be to invest narrowly or broadly, for risk/reward.

Even with perfect current information, you can't necessarily predict future performance. So it's not that everything would have the same return. I think that the randomization would come to play in evaluating growth stocks because you'd have the same understanding as everyone else and simply decide to gamble on risk vs reward.

I wouldn't attribute the growth or collapse to random shocks, though those would of course play a role. I'd say that new products and distribution methods would still cause rapid and somewhat unpredictable growth or collapse.

Straight value investing would be more difficult with perfect transparency and efficient information, though it might work out as a dividend thing.

Yes, sorry, we're saying the same thing, but I phrased it badly.

All stocks in a perfectly efficient market have the same EXPECTED return -- differential behavior can and will still occur, but it is necessarily unpredictable. Investing in any one stock is as good as investing in any other stock, in terms of expected returns. Now, there's still room for strategy in such a market: it's like, imagine the difference between betting $1 on a fair die, with one of two possible betting options: Either a 1-5 gets you nothing and a 6 gets you $7, or a 1 gets you nothing, a 2-4 gets you your $1 back, and a 5-6 gets you $2. In both cases, your expected return is 16% gain -- over enough iterations, you'll expect to gain money. But they are different in terms of risk/reward.

(And you can get similar risk/reward tradeoffs by investing broadly or narrowly in a perfectly efficient market.)

Valuation-weighted information is harmful. Remember the rule is to "buy low, sell high". When you weight by valuation, you're explicitly overweighting stocks that are valued highly by the market; in other words, you're buying high and selling low.

In theory you can do better with fundamental-weighting (i.e. weighting by revenues, earnings, P/E, PEG, etc.), but there are a lot of subtleties to a stock's future performance that are not captured in the financials and are exploitable against an investor that only naively looks at them. You end up with an investor that's picking up companies that are looting their future prospects for cash because their market is disappearing.

How about inverted valuation-weighing, then?

That's actually an interesting idea, except that you have no idea of knowing whether a company is worth very little because the market undervalues it, because it's intrinsically a small company, or because it's about to go bankrupt. An inverted valuation-weighted fund would put that vast majority of assets into stocks that are worth just above nothing. I suspect that a good portion of these are companies that are about to go bankrupt - probably a much bigger proportion than the ones that are small and about to take off, or the ones that are small and overlooked. Investing in companies that are about to go bankrupt isn't really a sound strategy.

The ultimate problem is that stock market returns are a future-prediction problem. When a stock does better than expected, it goes up. When it does worse than expected, it goes down. Doing this reliably includes both having a complete understanding of the rest of the market's expectations and knowledge of the future, which is pretty challenging.

I think that behavioral-finance approaches, which gauge the emotions of your fellow investors, have actually been shown to work pretty well. "Be fearful when others are greedy, and greedy when others are fearful." Hard to put that in an index, though.

> An inverted valuation-weighted fund would put that vast majority of assets into stocks that are worth just above nothing. I suspect that a good portion of these are companies that are about to go bankrupt - probably a much bigger proportion than the ones that are small and about to take off, or the ones that are small and overlooked. Investing in companies that are about to go bankrupt isn't really a sound strategy.

I don't know, isn't that what the junk-bonds guys did in the '80s, and more recent value investors? I could believe that the market still undervalues companies that are about to go bankrupt (but might not).

Because you are missing an important piece of information in angel investing, the buy price. Efficient market hypothesis says that for a publicly traded stock the stock price is the correct price, however a non-public stock wouldn't have a well established price.

Here's an interview with a guy who runs indices that are not valuation-based and seem to do better:

http://www.ritholtz.com/blog/2014/07/masters-in-business-rob...

A random buy is likely to be smallcap-biased, as there's simply more of them.

Smallcaps performed quite well over the past decade. Same strategy would not backtest with the same levels of success during any period.