Taken to its logical extreme, a monkey throwing darts at the stock market page of the newspaper should be able to perform as well as anyone else. Consistent with that idea, in 2013 a cat named Orlando bested professionals by throwing toy mice at a stock grid.3 (I was introduced to the theory by my college Economics 101 professor,4 who allowed us to choose five stocks any way we wished, including asking anyone we knew, while he threw darts at the Wall Street Journal. He beat most of us.)
This theory is very counterintuitive, however, so it is easy for those with a motive to cast doubt on it. Indeed, not only do thousands of companies and individuals who make their living from stock picking dismiss the theory but so do many economists. There is a huge difference, however, between those two groups. Economists write PhD dissertations arguing between strong, semi-strong, and weak forms of rational market theory, but virtually every serious economist acknowledges its validity. Folks whose livelihoods depend on choosing stocks, on the other hand, simply throw stones at the whole idea, completely rejecting it.
Most of us have our own doubts as well. We may tell ourselves that every year lots of stock-picking newsletters, brokerage companies, and mutual funds beat the market averages. “My own neighbor, Charlie, is way ahead of the markets this year.” How can the experts do no better than a bunch of amateurs? “I have based my whole life on the idea that doing research and working harder pays off in better results. . . . I just know that to be true.” The concept of a market that cannot be beaten through some sort of hard work is counterintuitive, and we just don’t quite believe it.
Don’t Confuse Random Chance with Skill
It is true that lots of stock pickers beat the market every year. That fact just confirms rational market theory, though, rather than refuting it. If nobody can successfully pick investments better than anyone else, it stands to reason that about half the pickers do better than the average at any one time and half do worse. The folks doing the picking hold this out as a demonstration of a special skill but, upon examination, it is easy to understand that this is merely mathematical probability working itself out.
Andrew Tobias5 helps us see this clearly: Line up 100 stock pickers (or children), give them each a penny, and ask them to try as hard as they can to flip heads. About half of them can do it successfully. “That is pure luck,” we say. Ask the successful ones to do it again, and about 25 of them flip heads a second time. Try again, and about 12 get heads for the third time in a row. Once more and about six flip heads for a fourth straight time. Flip again, we demand, and about three of them get heads for a fifth consecutive time. A sixth flip probably produces a single champion who was able to get heads in each of the six tries. We all know, however, that this does not represent any special talent for flipping heads. Rather, it is simply the law of chance. Our champion’s odds of getting heads on the next flip remain 50-50.
Random chance suggests that some stock pickers will beat the markets in any given short period of time. An interesting experiment, though, is to compare the records of actively managed (stock-picking) mutual funds with the market averages not over one or two years, but over 10, 20, 30 years, or longer. Despite what major fund managers may claim, the longer the time period, the fewer funds remain ahead of the market. In the meantime, we see huge ads trumpeting the successes without any mention of the failures, self-produced statistics that cannot be proven or replicated, and the tendency of the industry to close down or merge losing funds and obliterate them from their records. These and other tricks are used by fund companies to improve the appearance of their stock-picking records.
Everyone who goes to cocktail parties (or barbecues or fish fries) knows people who play the market. A remarkable number of those folks report that they are doing extremely well. Indeed, if you ask specifically, they will tell you that they are handily beating the market. Better take that with a grain of salt. In my professional career, I have never found a nonprofessional investor who keeps accurate records and is willing to share them. The acquaintances who are beating the market are doing so because they are not keeping accurate track. Human nature predisposes them to remember their winners and forget about their losers. (Ironically, the current level of regulation of hedge funds allows for a similar trick—they report their returns only when things are going well for them.)
Perhaps you recall the story of the Beardstown Ladies? This group of elderly investors was reported to have consistently beaten the market from 1983 to 1994, earning an average 23.4 percent per year. Their investing prowess was widely discussed across the nation. They were awarded a lucrative contract to write a book explaining how they were able to consistently achieve above-average returns. Notwithstanding what their book said, it turned out that the secret of their success was very simple. Their record-keeping system was flawed and, when examined properly, the actual return on their investments was very different from what they reported. In fact, the Beardstown Ladies had not beaten the market. From 1983 to 1994, they had earned an annual average of 9.1 percent,6 while the Standard & Poor’s 500-stock index returned 14.9 percent.7
But even if we give our neighbors the benefit of the doubt about their reports of success, none of them is beating the market over significant periods of time. The pros can’t even beat the market over many years. Care to guess the number of mutual fund managers who beat the benchmark Standard & Poor’s index every year between 1990 and 2005? One.8 Bill Miller became a household name because of that feat and earned more money than you could count in all your days.9 (Although subsequent years were not so kind to Mr. Miller, and by 2011 he was removed as full-time manager of the fund that he had made famous.) So the next time some Little League dad or storefront stockbroker tells you he regularly beats the market, ask to see his records—that will end the conversation.
Still, there is something deeply troubling about this efficient markets theory. It suggests that those who work hard, do their homework, put in the time and study, and really devote themselves will not do any better than those who throw darts. Even more disturbing, many of those hardworking investors will lag behind their neighbors who invest in index funds and know from the start that their performance will be just average. It is simply not the way we were brought up. It feels so Un-American (or Un-British, or Un-Moravian, or un-whatever your hardworking background). Surely there are rewards for working hard. These feelings of doubt and skepticism are played on by marketing campaigns that tell us we must get better stock research tools, and we should actively trade, and we ought to purchase the compilations of recent mutual fund performance records. In life, though, our gut intuition is not always correct, (try flying an airplane in a cloud or playing Three Card Monte with a street hustler), and the ads urging stock research are just trying to take advantage of us.
Stock Research Offers Little Value
It turns out that, despite what we are often told, research into individual companies cannot help you much in getting better investment returns. All the information you can turn up is already known by the experts on Wall Street,10 and they have already figured it into the price of the stock. Let me give you an example. Suppose you have done a great deal of research into Boeing (stock symbol BA) and find out that its commercial airliner business is booming. In mid-2013, Boeing stock had reached its all-time high of $103 per share and had generally been rising since 2007.11 Despite some technical teething pains with their Dreamliner jet, an impending union strike earlier in the year, and the impact of sequestration on its government sales, Boeing had an order backlog of $392 billion. This is a company with a solid future.
The thing to notice, though, is that Boeing stock currently sells at 19.4 times last year’s earnings precisely because its future looks good. The pros on Wall Street who have bid up the price to that level know every single thing that you know about the company. And they know more than that; they know the expected profit margin per plane, the number of new planes the airlines are expected to need, and the current thinking on Boeing’s prospects of winning
that next order away from rival Airbus (EADS). In other words, they know everything that you could possibly learn through your research (after all, whose reports do you think you are reading?), and they have already caused that information to be worked into the current value of the stock.
What does that mean: “worked into the current value of the stock”? How does that happen? Let’s try another example. Say that XYZ Company makes widgets and has 1 million shares of stock outstanding. Until today, everyone who pays attention to XYZ expected the company to make a profit of about $1 million a year (about $1.00 per share) this year and for the several years to come. Based on those projections, the stock has traded steadily at about $12 per share for a long time. At 11:00 A.M. this morning, you saw a news story on the internet saying that XYZ just got a huge government contract and the expectation is that the firm’s profits will double to $2 million a year for each of the next several years. You think to yourself, “Wow, XYZ is a real bargain in light of this good news.”
When you click to the stock market quotes, however, you see that the stock is already selling for $24 per share. What happened? The folks on Wall Street saw the same news and started buying the stock. They bought up all the shares that were offered at $13 and $14 and $15. They kept buying. The shares kept rising. More and more people read the news. The stock hit $16, $18, $20, but the pros kept buying because the stock was still a bargain even at $23 per share. However, at $24 per share, the stock was no longer a bargain because that is the price at which the profits from the new contract are fully factored in. And that is when Wall Street stopped buying. The stock stopped rising at $24, and that is where it remained by the time you went to the stock quotes page. The whole process may have taken less than a minute.
Research cannot help you with that. “But wait,” you say, “what if vigorous research allowed me to see that they were likely to get the contract before it was actually awarded?” Here is the difficulty: Let’s say you found out from public sources that XYZ might get that contract. More research told you that the odds of their winning the contract were 50-50. The problem is that all other investors, including very sophisticated Wall Street types, had access to that same information, and they, too, believed that XYZ had a 50-50 chance of getting that contract. If XYZ wins it, the stock is worth $24 per share; if they don’t get the contract, it is worth $12. By the time you turn away from your research and look at the stock quotes, you will find that the stock is trading for $18 per share (reflecting the 50-50 chance that the company will go from being worth $12 to being worth $24).
“Well,” you may ask, “what if I can gather information that nobody else has?” For example, let’s imagine that you are a world-famous domestic design and fashion maven. One day, while flying to a vacation on your private jet, your stockbroker calls to say that he just got off the phone with one of his other clients who is CEO of a company you have invested in. This other client let slip that some very important negative news about the company will be made public tomorrow morning. You have the opportunity to sell your shares before the stock falls the next day. Yes, that will work to give you the advantage you seek regarding this particular company. There are only two problems with this scenario: (1) You are not a world-famous domestic design and fashion maven for whom some broker is going to risk everything by sharing inside information; and (2) if you were the famous domestic design and fashion maven in our example, then you might be sent to jail for trading on inside information. It has been known to happen.
In general, you cannot get information that is unavailable to anyone else unless you have insider sources (you know, people within the company who know its secrets, etc.), and use of that insider information is quite illegal.
An example of the relative futility of this kind of research can be found by examining the recent history of automakers Ford (F) and Toyota (TM). Let’s say that in 2006, you set out to learn all you could about these two companies. You would have found that Toyota was the dominant player in the industry and was continuing a string of earnings increases. Ford, on the other hand, was having one of its worst years ever. In 2006, the company recorded a loss of $17 billion. Ford was in trouble and in danger of going under. Given these facts, it is very likely you would have deemed Toyota by far the stronger of the two companies. Given the opportunity, you undoubtedly would have preferred to invest in Toyota stock.
In the years that followed, however, Toyota’s stock stayed about even while the value of Ford nearly doubled. How can that be? It is as simple as the efficient markets theory.
Yes, Toyota was a better company. The stock price had already factored that in, though; Toyota had a market capitalization (the value Wall Street assigns to the company by multiplying all its shares by its price per share) 12 times greater than Ford’s. So the question you needed to ask in 2006 was not “Which is the better company?” but, rather, “Is Toyota worth more or less than 12 times the value of Ford?” Even that question is of limited utility since a lot of smart people who think a lot about the matter had determined that, at that time, Toyota was worth almost exactly 12 times what Ford was worth.
The answer to the overall question of which stock would perform better would be answered by unexpected and unpredictable future events. By their very definition, unexpected and unpredictable future events cannot be known in advance.
Earlier in this chapter, I wrote that economists disagree about rational market theory in that some argue for a strong version, some believe in a semi-strong variant, and others claim that a weak version is the correct way to understand the theory. If you are itching to do some research, you can look up the differences. For our purposes here, however, all you need to know is that none of these variations of the theory leads to the conclusion that average investors, or even experienced folks with millions of dollars, are going to be able to beat the market. Rather, this is an argument among academics as to whether inconsistencies exist in stock pricing that might be taken advantage of by, say, a huge Wall Street firm with hundreds of computers and the finest Ivy League minds to run them. Yes, there may be a few holes in the rational markets theory, but, no, you aren’t going to be able to make any money out of them.
Once you understand how markets work, you can see that no amount of research or historical study is going to make you rich. Most of the results you are observing are the reflection of random chance. Neither you nor anyone you can hire is going to be able to beat appropriate market benchmarks. One thing you get to do, once you realize these economic truths, is relax. There are now a dozen things you can just ignore. In turn, you can focus your efforts more robustly on those remaining things that will actually make a difference in getting you good investment outcomes.
Chapter Summary
Economists know that stock picking cannot consistently beat relevant benchmarks.
Nobody knows what a given investment will do in the coming weeks or months or one-year period.
There are no secret ways to beat the market that are legal.
Distinguish between what can be known and what is a reflection of random chance. Save your efforts for the former, and spend no energy on the latter.
Notes
1. Burton Malkiel, A Random Walk Down Wall Street (New York: W. W. Norton, 2007).
2. For simplicity, I may at times refer only to stocks but the theory holds for other investments, such as bonds, as well.
3. Mark Gongloff, “Stock-Picking Cat Named Orlando Trounces ‘Professionals,’” HuffingtonPost.com, January 15, 2013.
4. Professor Peter Kilby at Wesleyan University.
5. Andrew Tobias, The Only Investment Guide You Will Ever Need, 4th ed. (Orlando, FL: Harcourt, 2005).
6. Mark Gongloff, “Where Are They Now: The Beardstown Ladies,” Wall Street Journal, May 1, 2006.
7. http://money.cnn.com/data/markets/sandp.
8. William H. Miller III of Legg Mason.
9. Joe Light and Tom Lauricella, “A Star Exits After Value Falls,” Wall Street Journal, N
ovember 18, 2001.
10. The world is growing more mobile and connected by the day. People I refer to as “on Wall Street” are all sophisticated about investing, but they can be located in New York, Omaha, Bangalore, or anywhere else on earth.
11. Daniel Ferry, “Will Boeing Stock Fall Back to Earth?” The Motley Fool, May 24, 2013.
Chapter 27
Past Performance Does Not Guarantee Future Results
Past performance does not guarantee future results. We all know this to be true. After all, it is a requirement that this fact be stated in financial ads and prospectuses. We have read it a thousand times and memorized the words, the same way a smoker is familiar with health warning labels. Trouble is, we don’t quite believe it. Our instinct tells us that some people are more skilled at picking investments than others. Furthermore, we believe in the hot hand or the lucky streak. Sure, our statistics teacher told us that the champion coin flipper in the previous chapter was just a lucky recipient of the gift of random probability, but, deep in our hearts, we think he is more likely to flip heads again. Our gut and our brain are in conflict.
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