In the context of investing we all would like to “buy low and sell high.” A profit is made when you sell something for more than you paid for it. Thus, the question of how prices arise is naturally, a fundamental concern. Over the past few hundred years, thousands of the world’s greatest minds have worked to come up with ways to predict the future prices of financial assets – and for good reason. If I had a reliable model that could make such predictions, the financial rewards would be beyond measure.
Let’s say for example that I KNOW that a “Widget” that sells for $1 today will sell for about $2 a year from now. I don’t know about you, but I would sell everything I currently own, and borrow as much money as I could to buy units of that item for $1, or even a little more. Let’s say that by doing so I could come up with $1 million today. I would double my money in a year and be quite happy.
However, if I were truly clever, I would find a way to place bets on the future price of widgets instead of actually buying them. That way I don’t have to be stuck with a garage full of widgets for a year while my wife complains about having to park her car in the driveway. I don’t really want to pay for insurance on my widgets, provide security, take inventory, etc. As an alternate approach I might try to create a contract whereby someone promises to sell me widgets a year from now for $1 each. Since I know the market price at that point will be $2, I would write the contract for as many units as someone else would be willing to deliver, knowing that I would make a fortune. I would give these contracts a cute name like an “Option” because everyone likes to have more choices. Since everyone else would think that I was a fool, I might even be able to pay 10,000 people $100 each today to take this “bet” and promise to sell me 10,000 widgets a year from now for $1 each. In fact we could include in the contract, that they don’t have to literally deliver the widgets, we could just settle the account on the contracted date and no physical items ever have to be moved. This way I could turn my $1 million into $100 million (10,000 contracts times 10,000 units per contract) and never touch a real item. The point is that anyone with half a brain would be willing to pay virtually any price for a model that can reliably make such predictions because they could leverage that information into any amount of money that they wanted. That one piece of information can be worth billions to a player with more capital. That’s precisely why so much effort is routinely put into finding it.
At this point, you need to ask yourself an important question. If the smartest people alive have incentives this large to do something so simple and none of them have done it, is it reasonable for me to think that I have such a model in hand? Take this one step further. Is it reasonable to think that anyone has such a model? One final question. If anyone did have such a model, why on earth would they sell it to you? Keep in mind that one problem with having such a model is that as soon as the rest of the world finds out what it is, they will act accordingly. Knowing that widgets will be worth $2 a year from now motivates everyone else in the market to buy widgets for any price today below $2. As a result, buyers will bid up the price of this asset until it reaches roughly $2 today. At that point, knowing that it will be worth $2 a year a now becomes worthless information, since the profit has been squeezed out of the deal. That’s why I am not going to sell you my secret model.
That story is a form of the first argument that says that capital markets will be Efficient (although not perfectly efficient). In this context, Efficient means that the current price reflects all available information about the asset. For this to happen we must have a mechanism in place that allows billions of dollars to move instantly from one account to another to immediately incorporate new information, and we must have instruments in place that facilitate bets based on that information. This movement of funds drives prices up and down in real time. Of course, such a market does not exist for most privately held items and may or may not hold for my widgets. However, when it comes to financial assets like stocks and bonds, we get awfully close. When you consider financial assets that you might be able to put into a brokerage account or your retirement account like shares of publicly held companies, it would be extraordinary for the market for those assets to NOT be efficient, and extraordinary claims demand extraordinary evidence. In other words you are going to have to prove to me that this market is not efficient, and until you do I am going to assume that is it. This is why I say that when it comes to funds in retirement accounts you should behave as though the market is efficient unless you have incredible evidence to the contrary.
You will notice that I did not say that the market is “perfectly” efficient. That is clearly a theoretical construct, and not a perfect reflection of reality. Markets are made up of people and people do dumb things all the time. All I claim is that the markets that I care about come close enough to being efficient to make things like me trying to predict future prices a waste of my time. Technically speaking, market efficiency does not say some returns will not be higher than others. Just that the way the market prices these securities will be consistent with their risk profile. More risky assets will produce higher expected returns in exchange for forcing you to live with a higher variance. We will return to this topic in a later post.
If you don’t think these market are efficient you can conduct a simple experiment. Track the price of Apple stock while the CEO is giving his annual address to introduce new products. The moment he shows a new item and the crowd goes “wow” watch the stock price rise. On the other hand, as soon as he uses a word like “disappointing” or a phrase like “change of direction” or “difficult environment” watch the price fall. Its true that there may be a lag of a minute or two, but I have done this before and I can tell you that it will not be much longer than that. Large traders and money managers watch the events while literally sitting at their computers and they change bids and asking prices instantly based on what they hear. This moves the price up or down. Remember, they do not have to buy the actual shares. They can bid on options on those shares so that the actual item never has to change hands. These automated trades can be done in milliseconds. This is not perfect efficiency, but it is amazingly close.
I am now going to make the most controversial statement you are likely to hear today and many of you will laugh hysterically when I say it. Given that capital markets are very close to being perfectly efficient, all of the effort that you have ever made to pick the best stock to buy was almost certainly a complete waste of your time. Furthermore, it was almost certainly a waste of time for anyone who did it for someone else (unless they were charging a fee to do so). By extension it’s a waste of your time to try to pick the guy who picks the best stocks. Furthermore, it’s a complete waste of your time to pick the guy who picks the guy who picks the best stock, and so on. For each of those folks it is infinitely easier to take your money as a fee than to successfully predict market outcomes. And don’t forget, if they could actually predict the price, they have no good reason to tell you anyway.
If the market is efficient then trying to pick stocks won’t work, in the sense that it is not reasonable to expect to out-perform the market once your portfolio return is adjusted for the risk involved. Hiring someone to do it for you, such as a money manager, or a mutual fund manager won’t work either, especially since they are not going to do it free. Hiring someone like a Hedge fund manager who, in turn picks mutual funds to invest in has to be an even bigger waste of time and money.
For all of you who want to shout me down or laugh me out of the room, feel free. It doesn’t matter until you can prove me wrong – and you can’t. FULL STOP
