For most investors, we buy and sell capital assets via publicly traded markets. In the preceding post, I described how asset pricing underpins how much rational investors are willing to pay for an investment. When you bring investors together on the buy and sell sides of trades, that is a market. Markets are information processing machines and price is the product. The efficient market hypothesis is the idea that a market processes all currently known information about an asset’s prospects that the participants bring to the table. That makes it impossible to beat. This is an obvious thorn in the side of active managers or traders who claim to be able to do just that.
Those looking to beat the market must know more or be more accurate than the collective market intelligence. Plus, there must be enough inefficiency for them to capitalize on that. Learn more about how efficient the market is and use that to invest effectively to get paid. Wear that knowledge as armor to protect yourself from getting played. Played by your intuition and biases, and by other professional players.
The Efficient Market Hypothesis is False
One of the reasons why markets over and undershoot is that they are not completely efficient. They are populated by humans at some level. Our recency bias and emotions like fear or greed can cause the herd to stampede in one direction or the other. So, the efficient market hypothesis is false.
However, the inefficiencies are unpredictable about when they will start/end and in their direction. The more efficient a market is, the smaller and more fleeting those windows of opportunity from mispricing are. Why? Because efficient markets are constantly processing all known information into the current price. The efficiency of large liquid markets may not be perfect and instantaneous, but it is close enough not to matter.
Price Finding & Priced Risk
Investors estimate future expected cash flow and apply a discount to determine a fair price for that. There is risk because the future is unknown and those cash flows are not real until they hit your pocket. In a market, the participants compete on opposite sides of a transaction. They bring what they know about the possible future outcomes and their odds of happening. That is used to settle on the price.
So, it is a “priced risk”. It is inherent to the investment, and you cannot diversify it away. However, with assets expected to produce future cash flow, it is also a compensated risk. With the currently available information, you can expect to be compensated for the risk being taken. That is the kind of risk that you want to take as an investor because you can reasonably expect to get paid.
Markets Process Information to Find Price
Depending on the market size, scale up this concept of investors competing in a market to thousands, millions, or billions of transactions. The more participants, the more information is processed by the pricing machine. The more efficiently they can interact, the faster the information is processed.
This is critical to understand. For you to beat that market, you must know something more or better than that aggregate intelligence. If the efficient market hypothesis were true, then that would be the end of the story. However, different participants bring other non-financial goals to the table that may impact price. Still, those players are more likely to be smaller and the impact low because the market price is a weighted mean.
The aggregate market intelligence is dominated by the major professional institutional investors. They meet with managers, analyze, and compete fiercely for any piece of information that will give them a pricing edge. They have faster computers than even me. There are billions of dollars spent on this. They also don’t share that on media, in newsletters, or in any other way that could put their edge for managing their portfolios at risk. That is worth more to them. So, if you see it on TV. Hear it in the lounge at work, or from your financial advisor. It is priced in. Even if you don’t hear or see it, it is priced in.
Markets Are Efficient Enough
But wait! I started the last segment by saying that markets are not completely efficient. They over and undershoot price. This may happen due to the human participants, or even algorithms by The Borg Investors. It also takes time to process new information that affects price. The price is largely set through discounting future cash flows and that must adjust as the future unfolds into the present. The problem is that markets are efficient enough that we cannot reliably capitalize on inefficiencies.
The Dropped Loonie Analogy
Larry Swedroe gave a great analogy for the efficient market hypothesis. I will paraphrase it here with my own embellishments.
Imagine that “The Market” is a person. It could be Mr. Market or Ms. Market. Regardless, they wear a power suit and walk up and down Bay Street. They are not perfectly rational. Sometimes, they throw a fit or get excited. While waving their hands around (they are hand-talkers), they drop some of the money that they are carrying. Other times, they get caught off guard and bump into someone that they didn’t see. Knocking some money from their hands. One of the problems with trying to pick up the dropped money is that you have no idea when their mercurial emotions will flare or a random human pylon will get in their way.
Let’s say that you get lucky. You just happen to be walking behind them when they drop a dollar. The problem is that you are not alone on the sidewalk. It is crowded with other investors walking up and down Bay Street. You bend over to pick up the loonie and it is gone. Someone else with ninja reflexes already snatched it up.
The Pavlovian Danger of Delusion
The moral of the story is that markets are not perfectly efficient. Those who try to time the market or stock pick are not wrong when they point that out. The problem is that you don’t know when they will be inefficient and where. It is also a crowded space with fierce competition. This is important to understand because it is dangerous if you don’t.
Intermittent positive reinforcement is the strongest Pavlovian learning mechanism. Speculative investments feed that. Market timing and stock picking are speculative by nature. If you get lucky and then think that you can repeat that consistently, you will waste a lot of time walking up and down the sidewalk. You will be looking down as life passes you by. Some people even endanger their relationships and work by pursuing the dropped loonies.
Plus, it costs money to walk on the investing sidewalk. The brokerages and market makers collect the tolls. The government takes its share as taxes if you do happen to win. You may also lose money that falls out of your pocket to be snatched up by other investors along the way. The more you stick your hands in and out of your pockets, the more likely that is to happen.
Specialize in your career. Not in investing.
The dangerous allure of trying to beat the market is especially potent to high-income professionals and business owners. We are used to working harder, being smarter, and specializing in our business paying off. Part of why that works is that our professional fields are vastly less efficient than financial markets.
Further, the active management field is already crowded with specialists with massive resources at their disposal. Even though the efficient market hypothesis is false there is a theoretical chance to beat the market. In practice, active managers cannot consistently beat the market. In fact, those who have recently beaten the market are statistically more likely to trail it moving forward.
Why The Best Managers Can’t Win
To beat the current price, there must be a market inefficiency, you must recognize it, and it must persist long enough that you can capitalize on it, and the cost to do that must be less than the excess advantage. Each of those steps presents a problem in the real world.
As mentioned markets are not perfectly efficient. Markets with more participants, rapid freely flowing information, and low friction for trading are more efficient. That sentence just summed up publicly traded markets in the information age. While not meeting the dichotomous criterion of efficiency of the efficient market hypothesis, they are much closer to the efficient end of the spectrum.
Individual stocks may deviate more if their corner of the broader market is less efficient. However, those pockets require more friction to exist. That implies a smaller size and following. So, mosquitoes on the back of the broader market moose.
The competition to recognize and capitalize on those inefficiencies is fierce. It is also dominated by highly skilled professionals with better and faster access to information than retail investors have. Unfortunately for them, that doesn’t give them enough of an advantage to win consistently. Especially when you account for the costs to compete.
The Tour de Financial Markets
It is like being a professional cyclist. You can have the most expensive equipment, the best training, and the best genetics. However, all of the other competitors have that too and the increments between them are tiny. To win a race when you are all equally awesome usually comes down to who gets the right gusts of wind, hits pebbles in the road, or has an unforeseen mechanical issue. In other words, luck. They may all win a race at some point. However, the cost of competing is high and may outweigh the occasional prize purse.
That is the case with active investment management where the costs are very high, and the prizes from inefficiencies are small and fleeting. Fortunately for the top managers, they get sponsorships and endorsements that pay them handsomely whether they win or lose. You are those sponsors when you pay them to actively manage your money. They still get paid. You get played.
Skilled Managers Benefit From Scale. Investors do not.
Let’s say that there is an active investment manager that is exceptionally skilled. Skilled enough to consistently come out ahead, net of fees. Their fund or whatever structure they are managing will attract more capital. Unfortunately, it becomes increasingly difficult for them to deploy that capital to take advantage of their skill.
A famous paper by Berk and Green modeled that to demonstrate how rational investors using skilled managers get progressively less return. In contrast, as funds get larger, the management fees do scale up. So, even with a unicorn manager, you would need to identify them before their success and move on once they have become recognized.
Let’s take Berkshire Hathaway as an example. Warren Buffet and Charlie Munger are celebrated as two of the most skilled active managers of all time. If you had invested with them in the late 1960, you would have benefited from that. If you invested with them this century, you would have roughly matched the S&P 500. The chart below shows that most of the separation in performance took place early on. What are the odds that you’ll spot the next Warren Buffet before they are well-known due to their success?
You aren’t the next Warren Buffet either.
The argument of scaling difficulty is often used as an argument as to why you can stock pick and beat the large professional managers. Unfortunately, even though you don’t have scaling problems. It is unlikely that you can identify and capitalize on the fleeting market inefficiencies against the professionals who are gobbling up the anomalies that do pop up. I outlined all of the reasons why in the preceding sections, but it bears repeating.
Don’t get played by yourself. This is not trivial. The average cost of investor hubris from market timing is ~1.3/yr and stock picking ~0.8%/yr of underperformance. Those numbers are additive if you do both. Plus trading costs and taxes.
Don’t Get Played in Efficient Markets
It is easy to get fooled by those claiming to have the strategy for you to beat the market. Those strategies usually involve timing the market to buy a dip and sell a peak. Or picking the winners while avoiding the losers. Or picking the winners while they are temporarily down. Those strategies are very alluring in their simplicity. They make empiric sense and we have empiric evidence that markets are not perfectly efficient all of the time. However, remember these key points to avoid getting played by others. Or yourself.
Markets are information machines. Price is the product.
Remember that markets are pricing machines. The price is the weighted aggregate of all currently known probabilities. It is a weighted mean dominated by the professionals. You must know something better than they do to get a better price. You have to be able to beat the machine.
The efficient market hypothesis can be false, but it is true enough.
The efficient market hypothesis does not hold up in real life. However, large liquid markets are efficient enough that perfection is not required for you to get played. You cannot predict when or how inefficiency will show up. Don’t waste your life staring at the sidewalk looking for loonies. Or get your fingers stomped by the other walkers.
Luck is what differentiates the highly skilled.
When all competitors are equally highly skilled and have the best resources, then luck is what determines the outcome. You need to specialize to get to that level. In contrast to your career, where specialization in a constrained and inefficient market may lead to success. Taking the time and effort to specialize in market timing or stock picking does not extrapolate to success in relatively efficient markets.
Skilled managers make more. Their investors don’t.
They are as rare as unicorns, but some managers do consistently beat the market net of fees. Perhaps even over many years. Improbable outcomes do occur by random chance and it is a big pool of managers. Investment styles, like value vs growth, also go through long cycles of over and under-performance. Even if it is a result of skill, skilled managers attract more assets. Their strategic advantage is hard to scale up and the market-beating returns shrink as their managed assets grow.
You would need to discover them before they become well-known and their alpha disappears. Don’t get played by being sold the next unicorn – it probably isn’t and you won’t know in advance.
