A contribution to solving an old puzzle: why different trading strategies persist in competitive markets

Journal of the Academy of Business and Economics, Jan, 2004 by Jurgen Huber

ABSTRACT

A simulation study is used to explore, how valuable information in a market is and how useful different trading strategies are. While earlier work in this field covered this question only with two levels of information I use ten different levels to control carefully for the influence of additional information. The analysis shows that additional information is mostly useless and sometimes even harmful for low and average informed investors. It can be shown, that trading strategies exhibit kind of a 'decreasing marginal return', i.e. the more agents use a specific strategy, the worse its results are. This leads to the general conclusion that different information levels should use differing trading strategies--there is no single optimal strategy in financial markets.

1. INTRODUCTION

Everybody is talking about the 'information society' we are living in, but rarely does anybody ask, how valuable information really is. It has become kind of a paradigm to assume that information can never be harmful. Especially with respect to financial markets it is widely believed that traders with more information make better decisions and therefore gain higher profits. However, game theory reveals that "having more information ... can make a player worse off (Gibbons, 1992, 63). Even though the game-theoretical properties of markets are widely realized, little attention has been paid to potential consequences of these properties. With this paper I want to shed some light on this still quite dark field of research.

Apart from the efficient market hypothesis (Fama 1970) in its strongest form the existing literature, models, and experiments covering the value of information in markets mostly conclude, that additional information will make the possessor of information better off (for literature see below). For all of these studies I see a major shortcoming: they compare only two levels of information--uninformed vs. informed. Their common result, that the informed can outperform the uninformed traders, is no surprise. Until now, little consideration has been given to the impact of heterogeneously informed traders on the relation of information and return in capital markets. Yet it is a fundamental characteristic of modern stock markets that different agents receive different information signals and signals of different quality.

The rest of the paper is organized as follows: in Chapter 2 the basic intuition of the paper is given. In Chapter 3 the research question will be clarified before turning to the design of the market. Next I will examine the used trading strategies and then present the results of the simulation study. The analysis will be continued by changing trading strategies in the simulation to derive an equilibrium. The paper is concluded by summing up the major results in Chapter 5.

2. INTUITION AND RELATED LITERATURE

A market can be segmented into different groups after to the information level they possess: on the top end we have the insiders, who are the best informed and who can presumably outperform the market. This has been shown in theoretical, empirical and experimental work (e.g. Jaffe (1974); Seyhun (1986); Lin/Howe (1990); Lakonishok/Lee (2001); Ackert et al. (2002)).

Apart from insiders we have the vast field of 'low to average' informed traders. This includes most private investors but also the managers of actively managed funds. Finally there is a significant group of people who chose not to process any information but to either act randomly or buy an index paper. When asked about the performance of theses groups in the market most people would probably answer, that the return should increase with growing information level. We generally think that effort should and will be rewarded and that processing information will thereby help a trader to improve his performance in the market.

However, I object to this simple assumption--I also think that Insiders outperform the market, but I think that a random trader is on average more successful than an average informed investor. I agree with Malkiel (2003a, p.2), who argues, that "clearly all stocks have to be held by someone and if certain investors achieve above-average returns, then it must be the case that other investors are achieving below average performance ... after accounting for the additional expenses of active management, most investors must underperform the market average." But which ones are underperforming the market to which extent--and what can they do about it?

This leads to the starting point of this research: if the random walk hypothesis holds, a trader who does not gather any information but trades randomly can expect to earn the market return. There is no reason to assume any systematic over- or underperformance, if she really chooses her shares randomly, e.g. by throwing a dart arrow at a quotations list.

This leads to a puzzling situation: if Insiders gain above average returns and uninformed investors earn the market return, who is below the average? The only possible answer is: the average informed. A stylized fact supporting this is the performance of professionally managed funds: most high-paid funds managers are regularly not able to beat a broad market index, as shown in studies across the globe. On average about 70 percent of actively managed stock market funds were outperformed by the market over a ten-year period. Over the past ten years the median actively managed fund has produced annual returns 175 basis points lower than the index (Malkiel, 2003a, 4 and 9). Here we have highly-trained people trying to beat the market by processing information, but most of them achieve no better result than "a blindfolded monkey throwing darts at a newspaper's financial pages." (Malkiel, 1996, 24).