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 what 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 trading 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 investor 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; and 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 investor 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.

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