15.

481x Financial Market Dynamics

and Human Behavior
Andrew W. Lo, MIT
Lecture 2: Rejecting the Random Walk
and Efficient Markets

Lecture: Random Walk & Variance Ratio Tests

Contemporary Tests
of the Random Walk
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Variance Ratio Test
Basic Properties of the Random Walk

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Lecture 2 Slide 3
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 15.481
Variance Ratio Test
Basic Properties of the Random Walk

Xt

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Lecture 2 Slide 4
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 15.481
Variance Ratio Test
Lo and MacKinlay (1988)
§ Is the variance of two-week returns twice the variance of one-week returns?

§ In general:

§ Does r1 = 0?

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Lecture 2 Slide 5
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 15.481
Variance Ratio Test

Lo and MacKinlay (1988)

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Lecture 2 Slide 6
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 15.481
Rejecting the Random Walk

Source: Lo and MacKinlay (1988)

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Lecture 2 Slide 7
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 15.481
Rejecting the Random Walk

Source: Lo and MacKinlay (1988)

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Lecture 2 Slide 8
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 15.481
Rejecting the Random Walk
An Empirical Puzzle
§ Random walk strongly rejected for stock indexes
§ Random walk not rejected for individual stocks
§ Rejections stronger for smaller-cap stocks
§ Rejections stronger for daily and weekly returns
§ Rejections are due to positive autocorrelation
§ Rejections cannot be explained away by:
– Nonsynchronous trading, heteroskedasticity, January effect, size
effect

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Lecture 2 Slide 9
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 15.481
Rejecting the Random Walk

Source: Lo and MacKinlay (1990)

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Lecture 2 Slide 10
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 15.481
Rejecting the Random Walk
But Individual Stocks Are Not Autocorrelated!

Source: Lo and MacKinlay (1990)

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Lecture 2 Slide 11
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 15.481
Cross Effects and Lead/Lag Relations

Larger
??? and +
Large and + Small and –
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Lecture 2 Slide 12
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 15.481
Cross Effects and Lead/Lag Relations

Lo and MacKinlay (1990)

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Lecture 2 Slide 13
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 15.481
Cross Effects and Lead/Lag Rela<ons
Economics of Lead/Lag Relations
§ Effects are asymmetric
§ Classification and order of entries in the matrix matter:

§ Several potential explanations: learning, frictions

§ Implies importance of informational asymmetries, wider hedging
alternatives, and potentially profitable dynamic trading strategies

© 2020 by Andrew W. Lo
Lecture 2 Slide 14
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 Exploiting Non-
Random-Walk Behavior
 15.481
Basic Approach to Proprietary Trading
1. Buy assets if prices are forecasted to increase
2. Sell assets if prices are forecasted to decrease
3. Manage risk to minimize impact of incorrect forecasts
§ Note: “assets” can be securities, portfolios, strategies, or IP
§ Examples:
– Mean reversion: “what goes up must come down”
– Trends: “what goes up keeps going up”
– Relative value: mean reversion or trends on spreads
– Insurance: mean reversion or trends on volatility
§ Accuracy of forecasts relative to risk and costs

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Lecture 2 Slide 16
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 15.481
Mean Reversion and Contrarian Investing
A Specific Contrarian Strategy

§ Weights sum to zero; “arbitrage portfolio”

§ Can be multiplied by any factor (leverage!)
§ Think of weights as dollar amounts, not returns

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Lecture 2 Slide 17
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 15.481
Mean Reversion and Contrarian Inves<ng
A Specific Contrarian Strategy
§ Consider numerical example:
Ticker R t -1 R t-1 - R mt -1 It

AMZN 1.42% 1.22% $70.93

BBIO -1.14% -1.34% $77.91
FB 0.70% 0.50% $29.07
GOOG 0.20% 0.00% $0.00
MSFT 0.14% -0.06% $3.49
TSLA -0.12% -0.32% $18.60

R mt -1 0.20% Long $100.00

Short $100.00

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Lecture 2 Slide 18
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 15.481
Mean Reversion and Contrarian Investing
Profitability Can Be Quantified
§ Consider two stocks, a and b:

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Lecture 2 Slide 19
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 15.481
Mean Reversion and Contrarian Investing
Profitability Can Be Quantified
§ Consider two stocks, a and b:

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Lecture 2 Slide 20
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 15.481
Mean Reversion and Contrarian Inves<ng
Profitability Can Be Quantified More Generally

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Lecture 2 Slide 21
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 15.481
Mean Reversion and Contrarian Investing
How Cross-Effects Generate Profits

Security a: Rat Rat+1

Security b: Rbt Rbt+1

Market: Rmt Rmt+1

???

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Lecture 2 Slide 22
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 15.481
Mean Reversion and Contrarian Investing
How Cross-Effects Generate Profits

Security a: Rat Rat+1

Security b: Rbt Rbt+1

Market: Rmt Rmt+1

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Lecture 2 Slide 23
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 15.481
Mean Reversion and Contrarian Investing
Empirical Analysis in Lo and MacKinlay (1990)

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Lecture 2 Slide 24
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 15.481
Mean Reversion and Contrarian Investing
Empirical Analysis in Lo and MacKinlay (1990)
§ $1.694/$151.9 = 1.12% per week or 57.99% per year!
§ $100MM capital in 10 years time Þ $32.8 billion
§ How risky is this? See Lehmann (1990)
§ Smallest quintile: $4.532/$208.8 = 2.17% per week
§ However, this is still “academic”
– Must take into account commissions, bid/offer spreads, borrowing costs, short rebates, price
impact, data issues, technology infrastructure, risk management, compliance, etc.
– Frictions are critical for practice, but often assumed away by economists
– Coase (1937), “Nature of the Firm” and the role of transactions costs

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Lecture 2 Slide 25
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 15.481
Mean Reversion and Contrarian Inves<ng

Amazon Bestsellers Rank: Amazon Bestsellers Rank:

#877,023 in Books #4,673 in Books

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Lecture 2 Slide 26
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 15.481
Mean Reversion and Contrarian Inves<ng
Performance of Weekly Contrarian Trading Strategy
Annual Return (%) Annual Volatility (%)
90 90

80 80

70 70

60 60

Annual Volatility (%)

Annual Return (%)

50 50

40 40

30 30

20 20

10 10

0 0
1963
1965
1967
1969
1971
1973
1975
1977
1979
1981
1983
1985
1987
1989
1991
1993
1995
1997
1999
2001
2003
2005
2007
2009
2011
2013
2015
Source: Chaudhuri and Lo (2016)
© 2020 by Andrew W. Lo
Lecture 2 Slide 27
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 15.481
Mean Reversion and Contrarian Investing
Cumulative Return of DJCS Equity Market Neutral Index and S&P 500
January 1994 to December 2019
$12
S&P 500
CS Equity Market Neutral
$10
What Happened??
$8
(Lectures 3 and 7)

$6

$4

$2

$0
199312 199512 199712 199912 200112 200312 200512 200712 200912 201112 201312 201512 201712 201912

© 2020 by Andrew W. Lo
Lecture 2 Slide 28
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“Don’t be too proud of this
technological terror you’ve
constructed. The ability to
automate trading
destroy a planet is insignificant
next to the power of the Force.”
– D. Vader, Star Wars Episode IV:
A New Hope
 15.481
Next Time

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Lecture 2 Slide 30
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