7.10.15

Why Markets Are Efficient ... and what you should do about it

It may seem odd for me to declare that "markets are efficient" given that I have spent my career working (successfully) on investment strategies and businesses that "beat the market."

When I say that markets are efficient, I don't mean that I subscribe without qualification to the Efficient Market Hypothesis. Rather, I mean that the average investor should not expect to beat the market.


Financial markets are in fact riddled with inefficiencies.  But the average investor can't exploit those inefficiencies to make money.

Average (Retail) Investors

Almost everyone is an Average Investor.  For the purposes of an Average Investor markets are efficient.  Average Investors can't expect to pick stocks that will outperform the market on a risk-adjusted basis.  They can't expect to outperform markets by timing when they are in or out.

The key word here is expectation.  Simply due to chance it is certainly the case that a particular stock picker or market timer will get lucky and outperform the market.  But for every lucky pick there is an unlucky pick made by another Average Investor.*  So taken as a whole any particular Average Investor will do no better than the average of all investors.  We have a name for the average of all investors: The Market.

Even most professional money managers, including mutual fund managers and investment advisors, are Average Investors.  This fact is so well documented that it bewilders me that there are still money managers charging disproportionate fees for "active management."


So should you, as an Average Investor, do?  As I have written before: Know your risk tolerance.  Then buy and hold a diversified portfolio of low-cost market index funds that matches your risk tolerance.  Don't try to beat the market.  Just hope to keep up with it.

* There is a broad perception that it is possible to beat the market because the lucky investors tend to loudly advertise their luck – even delusionally attributing their luck to some repeatable skill – whereas unlucky investors are not so prone to tout their misfortune.  Further confusing the perception is the fact that there are businesses that beat the market, which brings us to the next section.

Specialists and Alpha

So what about those inefficiencies I mentioned earlier?  Who gets to take advantage of those to actually "beat the market?"

In the finance industry we refer to investment returns that "beat the market average" as "alpha."  There are all sorts and sources of alpha.  But especially in modern markets they all have one thing in common: They are not accessible to Average Investors.  It takes work to find and harvest alpha.  Alpha capture is a business.  Sometimes alpha businesses are wildly profitable.  (But so are businesses in every other industry.)  In rare cases an individual may stumble onto an overlooked source of alpha and make a vast fortune from it.  (But so do rare tycoons in every other industry.)  For most of us in the alpha business it takes a lot of work to find alpha and build a business to harvest it.

Many sources of alpha fall under the broad term "arbitrage."  In the financial markets arbitrage is strictly the domain of businesses like hedge funds and bank proprietary desks, which can bring to bear substantial resources to access and exploit fleeting and statistical inefficiencies.

In broad strokes, alpha businesses make their money exactly because they remove market inefficiencies.  And this is why Average Investors can't beat the financial markets.  Any more than they can hope to make money buying products on Amazon and reselling them from home.  Anyone who wants to make money as a merchant has to invest real time and money into doing so.  If they make a full-time job of it they might be able to earn a living.  But they will do so picking up the crumbs dropped by huge companies (like Amazon) that have more capital, better market access, and vastly cheaper logistical chains than anyone else

There are two noteworthy exceptions to this generalization:
  1. The individual with Special Information.  For example: You may work in healthcare, or construction, or some other industry where occasionally a relatively unknown product or company is coming to market.  If you have special information that is better than what the Average Investor can glean – better even than what the investment bank analysts that cover your industry can see – that some company is going to be a breakout success, and you can buy into that company before everyone else can see that; if your assessment based on your special information is correct, then you can earn excess returns (i.e., alpha) by investing on that.
  2. The individual with Special Access.  There are investment opportunities that are just not accessible to the market overall.  For example, only lawyers can own equity in a law firm.  (And only lawyers that are invited by the firm to do so!)  If legal or regulatory restrictions put a general bar on an investment, but you are exempt from that bar, then you can potentially earn better risk-adjusted returns on that investment than you could in the public financial markets.

23.2.10

Retail Investing

A "retail investor" is anyone who is not a professional investor or money manager.  If you have money that you can afford to leave invested for a time in assets that are more risky than a bank savings account, then you can expect for that money to earn more for you than it would at the risk-free interest rate (which may not even keep up with inflation).

A generation ago market investing and portfolio construction was considered a skilled art best left to professionals.
  1. There was an erroneous (and now thoroughly debunked) belief that professional "active" mutual fund managers could deliver better performance than one could get by "passively" tracking the market overall.  Active fund managers still charge annual fees ranging from 1-3% (and even more!).  On average, investors in their funds end up underperforming the associated market by exactly the amount of those fees.
  2. The theory behind optimal portfolio construction was not well developed, so most individual investors paid an investment advisor to allocate their money to try to match their risk tolerance and personal financial goals.
Market investing today has never been easier, more transparent, or more efficient.
  1. A number of large investment companies, led by Vanguard,* offer low- or zero-cost "passive" funds that allow investors to assemble a diverse portfolio that matches the returns of market indices.
  2. The fundamentals of portfolio construction are also mainstream.  Plenty of companies and websites offer questionnaires and calculators to help individuals find a mix of asset classes that are appropriate for their specific risk tolerance.
Using these retail tools any individual can, with minimal expense, put together a diverse portfolio of financial securities that performs as well as portfolios compiled by professionals.  

Lamentably, the investment advisory industry has been slow adapt to these changes.  I find many individual investors still paying financial advisors or asset management companies anywhere from .5% to 1.5% per year of investable money to compile an efficient and diversified portfolio.  I disapprove of such businesses for several reasons:
  1. Advisory expenses do not significantly increase with the amount of assets under management, so they should not charge a fee that is a function of assets under management.
  2. Money managers cannot reliably increase risk-adjusted returns through active allocation, so they should not charge a fee that is a function of assets under management. (You will, of course, continue to see managers who advertise their record of “beating the market.” The problem is that nobody can predict ahead of time which managers will outperform their benchmark. Just because someone did it for ten years doesn’t mean they’ll do it for an eleventh. There is ample evidence that, on average, active managers underperform their benchmarks — by an amount roughly equal to the average they charge in fees. Cut out the middleman and keep the fees for yourself!)

* Why I prefer mutual funds from VanguardVanguard is a true mutual company, meaning that it is owned by its customers.  This means that it faces no conflicts of interest with the investors in its funds.  For example, Vanguard funds have been known to turn away large institutional investors with characteristics that could negatively impact the profit of its existing retail investors.  The eminent professional investor David Swensen, who managed Yale's endowment for a number of years, aptly elaborated:
[T]here’s an irreconcilable conflict in the mutual fund industry between the profit motive and fiduciary responsibility. There are two major organizations, Vanguard and TIAA-CREF, which operate on a not-for-profit basis. That conflict between profit and fiduciary duty disappears. Vanguard and TIAA-CREF are dedicated to serving their investors. They are shining beacons in this otherwise ugly morass.