Risk and the Value Line Contest

Abstract

Most of the direct evidence on portfolio and efficient markets theory developed in recent academic research requires a good mathematical and statistical background for comprehension. (Descriptions of purported contrary evidence can often be simply understood, but equally often contain serious theoretical and technical errors which are difficult to explain simply.) The Value Line Contest has enabled us to submit the academicians' results to a partial test that we can describe, and readers can understand, without mathematics. We hope our success in playing Value Line's game will signal to investors the importance of explicitly considering systematic risk and overall market movements before making decisions about individual stocks or before accepting stock recommendations. Value Line analyzes and ranks more than 1400 stocks. Periodically, Value Line stages a contest to attract investors' attention. To enter the most recent contest, one picked a portfolio of 25 stocks from the Value Line list. Contestants' portfolios are ranked by the average percentage increase in price of their 25 stocks over the contest period (which for the most recent contest was the six months beginning August 18, 1972 and ending February 16, 1973). The typical entrant in the Value Line Contest attempts to use his or her skills in security analysis to choose the 25 stocks likely to appreciate most in price over the contest period. Value Line expects that portfolios chosen from the stocks it ranks highest will outperform those chosen in other ways. If this expectation is realized, contestants and others who follow the contest may be sufficiently impressed to purchase Value Line's services on a regular basis. We entered the contest but we paid no attention to Value Line's rankings nor, for that matter, to any other source of analysis. Our strategy was based on implications of recent research on portfolio theory and efficient markets. We described our strategy and predicted its results on August 15, 1972 during the week preceding the start of the contest. The written description is reproduced in the appendix of this article. The original document was given to Richard M. Cyert, President of Carnegie-Mellon University, who signed, dated, and filed it (see letter next page). As you will see, our predictions were accurate and, if anything, too cautious. If capital markets are efficient,' security prices rationally reflect all publicly available information (including the recommendations and opinions of the Value Line Survey). A corollary of the efficient market theory is that two portfolios of equal risk are expected to have equal rates of return, even if one consists solely of stocks ranked in Group I (highest appreciation potential) by Value Line and one consists solely of stocks ranked in Robert S. Kaplan is Professor of Industrial Administration, Graduate School of Industrial Administration, Carnegie-Mellon University. Together with Rich.ard Roll he is author o,f Accounting Information and Stock Prices in the January-February 1973 issue of this Journal.