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INHERENT BIAS

The belief that one can predict the behavior of some process such as the determination of stock/commodity prices, makes the implicit assumption that that process is non-random. Otherwise, one is depending totally on luck and any system that one develops to predict prices will not work over an extended period of time.

But, if it isn¡¯t totally random and completely independent, then there may be a place for a type of analysis that allows us to discern the underlying pattern in the specific market and to thereby profit from it.

It has been suggested that all known information about a stock/commodity is already factored into the price. In this fashion, no one has an unfair advantage over the rest of the trading/investing universe. The conclusion, therefore, is that anything that changes the price at a point in the future is unknown at the present moment, is not expected, and therefore is deemed to be random in nature. The corollary is that prices are continually adjusted as new information becomes available, and that the fair value is therefore maintained by the action between the buyers and sellers in the marketplace.

To test this premise, the most commonly used example of a random and independent process is tossing a coin. When you toss a coin in the air, whether it lands on heads or tails is determined randomly. It would make sense to expect an approximately even distribution of heads and tails over a large series of throws. The independence inherent in the process is if you throw the coin four times and get four tails, this has no influence on the outcome of the fifth throw. It is as likely to come up a head or tail as the first throw.

The belief that what came before in some way influences the ensuing toss is often referred to as the Gamblers Paradox because many gamblers believe that a run of four tails should be more likely to produce a head as the result on the next toss.

Imagine a soldier, fresh out of boot camp, who is quite drunk as his military graduation celebration got too out of hand. He stumbles into the street and begins to try to find his way back to his beloved bed. Every step he takes while in this stupor is truly random, having completely lost access to the faculties that could guide him to the barracks.

One step forward, two steps backward¡­¡­¡­.. on and on it plays out in a completely random fashion. A statistician would tell you that after 100 such paces, in all likelihood our soldier would be right back at the point from where he started. The reasoning would be that reflective of true randomness, the expectation of clear progress in any given direction, simply isn¡¯t reasonable and therefore the soldier is most likely to be right back (or quite close to) his original departure point.

But, does the market behaves in just such a random fashion

To do that, we examined that daily data for the S&P 500 Index going back to 1960 which is over 11000 data sets.

But, if the prices were truly determined randomly, then we should have about 5500 wins and a like number of losses; a true 50-50 balancing act. But that wasn¡¯t the case.

Instead, the look-back revealed that the Index was actually up on 52.4% of the days examined. Admittedly, a small edge; but one that seems to be statistically significant.

Having a solid understanding of the ¡°statistics¡± of gambling, we knew that it was just this kind of small edge that has kept the casinos thriving for decades. To put it all in perspective, look at the table below detailing the ¡°house bias¡± on two of the most popular games of chance and then compare it to the S&P data:

Craps	.507
Roulette (American)	.526
S&P 500 Index	.532

Could it be possible that there was an inherent bias to the upside; one that made buying the Index tantamount to being ¡°the house¡±? Or was the bias little more than reflecting the bull market that began in 1982?

We knew that the answer would be discerned by using more data. So we examined more than 25000 daily data sets comprising the Dow Jones Industrials since January 1, 1900. This could very well be a fairer view as it was composed of bull markets, bear markets, and trend-less periods as well.

The findings were a real surprise; 52.9% of the days reviewed were to the upside. This was a bias that almost perfectly matched the one enjoyed by American Roulette. With a  standard deviation of only .009%, this meant that more than 95% of the time over the last century, the ¡°house¡± had the clear advantage and that going Long was the way to be the ¡°house¡±

Casinos use these very principles by which to garner their huge profits. While at first glance the small percentages might not seem significant, they are compounded each and every minute as another game (trial) is played.

Savvy market participants can have the same advantage as the casino operator by finding markets that have this clear and discernable Market Bias and positioning themselves to benefit from the ¡°house¡± edge that they will receive.

The 2001-05 compound annual rate of growth for our stocks simulation is 42.2% whereas the S&P 500 had negative growth for the period. Through Sep 2006, performance was a gain of 13.3%. Learn more here.

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