May 14, 2007

How to Beat the Market

There's an idea within finance called the Efficient Markets Hypothesis (EMH). Basically, this hypothesis (it hasn't been conclusively proven either way) says that market prices, including stock prices, are basically random and unpredictable. If true, this would mean that it is impossible to beat the market as a whole, which would be a huge revelation in this age of actively managed mutual and hedge funds. It would mean that there is no way of predicting stock prices long term, and so any group of stocks has an equal expected return. Thus, there would be no reason for anyone to pay for active management. Of course, in the short run, it is entirely possible to beat the market, most people don't invest for the short term.

For good reason, EMH has been a source of much research. What the research finds is that market prices roughly reflect all historical data, meaning that anything that has happened in the past is already priced in to the market. This means that only new information can affect stock prices. This makes intuitive sense, and though it hasn't been conclusively proven, there seems to be quite a bit of evidence suggesting that this is the case. It's also been all but proven within academia that actively managed funds do not beat the market in the long term. While there is much more to EMH than what I've said, this seems to be the jist of it as it applies to today's investment landscape and to what I have to say here.

Another idea within finance is diversification, which almost everyone is familiar with. In the jargon of the financial world, diversification leads to less risk without sacrificing the level of returns. Practically, owning two uncorrelated stocks equally will have the same or similar return as owning just one, but with substantially reduced risk. However, diversification only mitigates so-called business-specific risk and cannot lessen overall market risk, which affects all stocks. Again, this is intuitive as you can lessen the impact of things that only affect one or a few businesses, but you cannot escape events that affect the entire market, i.e., all businesses.

If you own a sufficiently large basket of stocks (most estimates are 30-40) that are all independent of each other, the only risks you will be facing are risks to the entire market or the overall economy. As you gain more positions in different industries, I think your portfolio becomes more representative of the overall market, with risk and returns approaching those of the market itself. If I'm correct, than a sufficiently large number of stocks will have risk and returns similar to the market as a whole.

The point is that if this is all true, as it seems to me to be, than the only way to beat the market is to own a small number of stocks. Perhaps the reason mutual funds can't beat the market in the long term is because their portfolios are too broad, so they tend to mimic the market itself. This also means that to beat the market means to take on extra risk, which should mean that it takes extra effort to manage fewer positions well since each one is capable of higher returns but involves substantial risk.

The result of all of this is that noone can achieve returns in excess of those earned by the entire market (long term) except by owning a small number of well-chosen stocks. "Well-chosen" implies that much care must be taken and the investor must have the time and knowledge to find and choose these stocks well (whether such knowledge comes from a textbook or not is another question). If that knowledge and time is not there, then the investor must accept the risk and return of the entire market. In other words, the only way to beat the market logn term is to try to accumulate successive short term gains in excess of the market, to play the market short term over and over until you are finished investing.

Of course, mutual funds could take this advice and only invest in a few positions, but then one of the largest benefits of mutual funds, diversification, is lost. Also, when a fund has hundreds of millions of dollars, they cannot put a significant percentage in any one stock without moving the stock price. Thus, any favorable change cannot be taken advantage of before it is totally priced into the market. Similarly, negative changes could not be escaped without pushing the price lower and making it worse. Perhaps this, and not EMH, could be why mutual funds cannot beat the market. They are too large to benefit from the strategy of holding fewer positions.

The conlusion, then, is that the return on the market as a whole should be the guaranteed minimum for an intelligent investor (investing in a representative index fund). Thus, the only criteria for determining returns is whether or not the investor chooses to pursue higher returns in the first place, and the skill level and time committment of that investor in seeking successive short term gains.

Posted by chupathingy on May,14, 2007 at 1:36 AM | Comments (3)

That's why I recommend if you're going to invest in a broad mutual fund, invest in an index fund. Low fees/load. You track the market and don't line an investment bankers million dollar bonus.

Comment by: Dave at 7:28 PM, May, 14, 2007

Another vote for index funds. High load / expense ratios are going to eat your returns long term.

I have been reading recently about a different kind of index fund. Instead of using a market-cap index, like the S&P 500 flavored funds, there's different ways of doing valuation-weighting. It's still a broad-based approach but works on what a company's calculated value is rather than their market cap. While I wasn't jumping to switch, I thought it was an interesting spin.

Keep in mind there are other ways to diversify, like getting your mix of stocks/bonds right (though that probably becomes more important later in life) and hitting up some international funds too. Remember you're also dealing with currency risk there, but that can also be another form of diversification.

In many ways, I'm not as much concerned about beating the market as I am about not getting screwed. This is partly because of my personality, but also because in the long term, the market doesn't do too shabby. If you get jittery and sell when something goes wrong, you might miss the rebound. I feel like that's the kind of thing that would mess up your long-term returns more than not squeezing every penny out of the market.

Seems like there's some value to having a core index fund, but playing around with some stocks individually too?

Comment by: matt good at 2:44 PM, May, 23, 2007

I was only talking about the stock market, but yes you can diversify your overall portfolio outside of the stock market. However, in this age of funds galore, you could find an Exchange Traded Fund (ETF) or a mutual fund that will basically mirror bonds or real estate or foreign currencies or just about anything else.

There are tons of ways to value companies or indeces or funds. Common index valutations are market capitalization (like the S&P 500) or price (Like the Dow Industrial Average). There are lots more to value companies. If anyone had a perfect system for valuation, the markets would be, to use the terms of EMH, strongly Efficient and it would be impossible to game.

Comment by: neil at 12:22 AM, May, 27, 2007