Markets Are Efficient

I would like to thank Greg Phelps for today’s article about Efficient Markets.  Greg Phelps, CFP®, CLU®, AIF®, AAMS® is a 20+ year industry veteran.  His firm Redrock Wealth Management provides fee only fiduciary financial advice and retirement planning to clients in the Las Vegas area.

 

In 1965 Eugene Francis “Gene” Fama, (CEO of Dimensional Fund Advisors and Nobel laureate in Economics), proposed the core concepts of market efficiency. This concept can reduce your investment risk and help ensure you achieve the performance your financial plan requires.

Gene was the first to introduce the efficient market hypothesis. The concept is so simple it doesn’t take a financial genius to understand it. I’m actually shocked most investors – and Wall Street – doesn’t understand it.

I suppose there’s probably a good reason Wall Street doesn’t “get it”. Wall Street want’s you think they own the “secret sauce” to investing. If investing was easy (as EMH makes it) you wouldn’t need Wall Street’s overpaid analysts telling you what to invest in. They’d lose revenue, so Wall Street needs you to need them!

EMH doesn’t make headlines, and it’s not fun or sexy. In fact, EMH is just plain boring. But boring is good sometimes, boring is effective.

What is the “efficient market hypothesis?”guy-computer-investing

There are two types of investing “styles”, active investing and passive investing. If you believe in the efficient market hypothesis, you’re a “passive investor”. If you believe markets are inefficient, and you can outpace other investors by good security selection and/or market timing, you’re an “active investor”.

In my own words, here is the efficient market hypothesis:

A security is worth the highest price a buyer will pay and the lowest price a seller will accept at all times. Since information is available to the masses at the speed of the internet, current prices and future expectations are judged by all investors equally. Therefore you cannot buy an “undervalued” asset or sell an “overvalued” asset; hence you cannot “beat the market” consistently or predictably by trading individual securities.

 [1]Source: Eugene F. Fama, Market efficiency, long-term returns, and behavioral finance. Journal of Financial Economics, Vol. 49, Issue 3, September 1998, pages 283 – 306.
 

Simply put, there is no secret sauce to investing. A security is worth what it’s trading for at any given moment.

If securities are always fairly valued, is it possible to beat the market? Is it possible to know which one will outperform the next?

No, it’s not. Not according to EMH anyway. Of course, statistically speaking some managers and traders will always beat the benchmark indexes. By default, some must beat the index or no one would invest in anything but the indexes.

That being said, beating the benchmark index isn’t much more than luck. Throw enough darts at a dartboard, and eventually you’ll hit a bullseye!

The best price is the current price

When my boys were young, my wife and I spent an awful lot of time at local parks.  Every once in a while the boys would want to go running after the ice cream truck.

ice cream

Let’s say a milkshake was about $2.00, and a Creamsicle® maybe $1.25. Ice cream cones were the cheapest at $1.00, and a snow cone about $1.50.

Market forces set those prices. We trust market forces set efficient prices everyday. The price is always the most a buyer will pay, and the least a seller will sell for.

If milkshake sales struggle, you’ll likely see a drop in the price. If the ice cream truck driver keeps running out of ice cream cones, you’ll likely see the price of ice cream cones rise to maintain inventory and increase profits.

Prices are determined by supply and demand, i.e. market forces. Stocks, bonds, and every other investment are no different. Your house isn’t any different either, it’s only worth what a buyer with cash in hand will pay on any give day.

The collective wisdom of the masses

Millions of investors and managers are constantly analyzing and trading securities around the clock. They each have their own opinions on what direction a security is headed. Up, down, sideways? They all “think” they know.

For every buyer who thinks a stock or bond is going up, there’s a seller on the other side of the trade who thinks it’s going down. Who’s right… you or him?

For every overpaid highly educated analyst at your brokerage firm, there’s an equally overpaid highly educated analyst at your neighbor’s brokerage firm. Whose analyst is right… yours or his?

You’re not right; your analyst isn’t either. Your neighbor isn’t, and the magazines aren’t. In fact no one is right, but the collective thoughts of the masses are! Marbles

Have you ever been to a fair where they ask you to guess the number of marbles (or beans or pennies) in a jar? If you’re the closest to the correct number you win a prize.

As it turns out it’s not the smartest guesser that’s usually closest; it’s the average of all guesses that’s closest. This is called swarm intelligence 2, and it simply states that masses of average intelligence are better than any individual’s intelligence.
Many studies have been done on swarm intelligence. In 2008 researchers did a study at the Max Liebermann Haus of the Stiftung Brandenburger Tor (in Berlin, Germany). They had a jar with 569 marbles in it and participants were asked to guess how many marbles were in the jar. Out of 2,057 guesses the average guess was 554. It’s pretty amazing how close the masses were to the correct number of marbles.

Swarm intelligence shows that in a large group, the average of all guesses is most accurate, not the “smartest” guy’s guess. So I ask you, if there are masses of investors pricing stocks, bonds, and ice cream every second – what makes you think you’re right and they’re wrong?

[2] 2011 The Association for the Study of Animal Behaviour; Swarm intelligence in humans: diversity can trump ability; Stefan Krause, Richard James, Jolyon J. Faria, Graeme D. Ruxton, Jens Krause.
 

The upcoming election is no different

Recently, I’ve had many many investors saying “the markets will tank if Trump is elected”. The funny part is for every investor making that claim, the next client comes in and says “the markets will tank if Hillary is elected”.

So who’s right? Client A or Client B? The stock and bond markets are where they are right now based on all available information. Securities are priced fairly at all times based on knowledge and expectations for the future.

What’s even more curious is the Brexit vote. Masses of investors expected it to fail. Very few thought it would pass. Polling showed it would not pass as well.

When Brexit passed, the markets tanked – for a minute! It’s the old “buy on rumors, sell on news” theory. Investors bid up a stock in anticipation of upcoming earnings reports. Typically, no matter how good the news it the stock will sell off after reporting.

I suspect like Brexit, the stock market will drop no matter who is elected President. I also suspect it will be a short term blip on it’s permanent march towards higher long term prices.

Is there a secret sauce to investing?

You’re not smarter than the markets. I’m not smarter. Fortunately, no one else is either! Statistically however, some do get lucky. You must understand that “luck” is not “skill”.

Of course you don’t know what corporate insiders know. You don’t have inside information that would make buying a stock cheap – or selling a stock high – possible. If you did and acted on it you’d be on a fast-track to jail!

Aside from inside information, a stock is always worth what it’s trading for. The same goes for bonds, or your house, and every other investment. They’re worth what someone will pay and what the counterparty will accept based on all available information on any given day – not a penny more or less.

To reiterate, you cannot “beat the market”. I realize you’ve been told for years through slick ads and entertaining TV shows that you, or your advisor/manager, could pick the best stocks, or buy the best bonds. This is the great lie of the financial media.

And what exactly are the best stocks or bonds anyway? Do they beat the market? Do they have the highest return or the lowest risk? Maybe the highest dividend or interest rate?

The fact is the best stocks or bonds are all the stocks or bonds in an asset class because asset classes outperform the best and brightest investment managers far more often than not. Just take a quick look at the SPIVA Scorecards. They clearly show that the majority of indexes beat active managers. Over long periods of time, the percentage of managers losing to the index increases.

Since all information is available worldwide at internet speed, every security is fairly valued and markets are efficient. Since markets are efficient, you cannot beat the market consistently or predictably, therefore there’s no point in taking the risk of trading individual securities.

So what does this mean to you and your financial planning?

When it comes to your finances, the most important thing you need to do first is have a plan! Planning trumps all investment opportunities, because failing to plan is planning to fail (Benjamin Franklin).

Aside from quality financial planning, like my colleague Dave Fernandez at Wealth Engineering does, investing should be looked at as a tool to execute your plan. While the tool is important, the plan is critical.

Since all the stats show index investing beats active investing, become and index minded investor first. Thereafter, you can search for ways to tilt and tweak indexes to improve returns. Mutual funds by Dimensional Fund Advisors are a good place to start!