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Summary

As humans, we tend to see patterns in our lives from completely random events. We also try to find meaningful patterns in stock prices for our exploitation and thus make some high returns. Unfortunately, most of the patterns we find are merely our attempts to make sense out of completely random events. Better technology does not make the search any easier. If someone is trying to sell you on investing through a set of fixed filter rules, watch out! First, see if there is a reasonable explanation that causes the mispricing being captured by the trading rules. Second, see if the rules work in out-of-sample tests. Most of the time, trading strategies do not meet these two tests and should be avoided.

In the short term, prices follow a random walk that makes predicting the direction of a stock price change impossible on a continuous basis. In the long run, stock price changes follow a random walk with an upward drift. This drift is the return made by the well-diversified investor with a long-term focus. However, randomness affects the long-term investor if he or she is not well diversified. Therefore, a large portion of an investor's return may be considered the result of luck if he or she either is underdiversified or has a short-term focus. This will be good luck some of the time and bad luck at other times. If the performances of many investment managers are examined, a few are bound to have done very well as a result of luck. A few will have done well because of skill. It is hard to tell the difference between the lucky managers and the skillful ones. If given enough time, we would eventually be able to tell them apart. However, as investors, we must make decisions sooner rather than later.


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