Via the Economist, a nice reminder that it doesn’t make a lot of sense to try and beat the market yourself, and even less sense to pay somebody else to do it (and it’ll cost you dearly). The market’s efficient – it’ll efficiently punish you for trying. I know, somewhat of an old story; you won’t win any shiny gold coins with that one anymore. Yet, people like to tell tales of those exceptional geniuses who defiantly manage to outperform the S&P500 in the epic battle that is the financial market.
On the other hand, you also won’t get any medals anymore for pointing out that many investors seem to behave rather irrationally (for example, they’re willing to pay somebody else to beat the market). Yet we think of the sum total of the chaotic, unpredictable, occasionally (asset) bubbly behavior of those people as a – maybe the one true – efficient market. In finance, it seems to me, familiar words have peculiar meanings.
Beasts of the Stubborn Wilds
Somewhere out there among the canid natives to the wilderness and remote areas of North America, Eurasia, and North Africa of Wall Street, the mythical market beaters roam. Those who know where the ‘value stocks’ are at. Who have stubbornly resisted efficient market hypotheses. That they exists at all may seem odd for a second, given that I specifically stressed that active trading isn’t a very lucrative prospect. Then, you’ll realize that given the number of people who want to ascend to the ranks of those fabled few, it’s pretty obvious that some of them are gonna make it. It’s just that the overwhelming majority won’t.
There’s another problem: nobody knows who they are! You can’t look at past performance, because that’s not an indicator of future performance. More importantly, it’s no good if you know that somebody outperformed the index for the last ten years. You wanna know that they’re going to do well over the next few years! Unless you found a golden tablet inscribed with the names of all the great hedge fund managers that were, are, and will be, you’re screwed.
Overall, the whole idea of active investing doesn’t seem like a terribly efficient deal. But if people just like playing Leo DeCaprio, why not let them? So long as the underlying market is efficient, we’re golden, right?
The boy who cried grossly overvalued
Because stock returns move around so wildly (while things like GDP usually rise over time), it might seem that the process creating those returns can’t be terribly efficient. They don’t seem to follow a pattern. Paul Samuelson of course resolved that puzzle, proving that prices that incorporate all available information at any point in time will seem to fluctuate randomly. Samuelson was a really smart guy though. Which is why, in that same paper, he also said:
One should not read too much into the established theorem. […] It does not say that speculation […] or that randomness of prices is a good thing. It does not prove that anyone who makes money in speculation […] has accomplished something good for society. All or none of these may be true, but that would require a different investigation.
That part of the paper seems to get less press. Fama and Shiller of course both tried to deliver that ‘different investigation’. Are stock movements unpredictable because they instantly soak up new information? Or do they seem crazy because investing fads and bubbles are simply crazy, crazy things?
I won’t try to resolve that age-old debate here. Although I will say that it doesn’t seem overwhelmingly rational (or even smart) to buy a bunch of dot.com stocks, then have someone tell you that that’s crazy (“those companies are grossly overvalued!”), and then go nuts with fire sales. Unless, of course, you only bought them because someone else (or possibly the same person, if your broker’s really good) told you that dot.com wasn’t crazy at all.
You can’t cheat an honest man with a dictionary
My point is this: how on earth did we ever decide to use the term efficiency in this context?! Of all the wonderful words we have at our disposal to describe what’s going on with stock returns, why did we choose one that makes absolutely no sense? Let me illustrate:
- unpredictable markets hypothesis
- random stuff happens hypothesis
- index funds rule (on average) hypothesis
- ARIMA(0,1,0) hypothesis (that last one’s a little too nerdy to really catch on with Wall Street types I fear)
So please, take your pick. I’m also open to suggestions! But let’s find an expression that’s more accurate, and less of an abuse of the English language.