Why is it so difficult to beat the market?

 

Financial markets and agriculture are the two of the most cited examples of markets that approach what economists call Perfect Competition. The characteristics of a perfectly competitive market are: 

• A large number of buyers and sellers
• No buyer or seller has the power to impact the price
• The market dictates the price thus everybody is a price taker
• Output is homogeneous thus nobody can tell the difference between the output of one producer and another producer
• Information is symmetric thus both buyers and sellers have a complete knowledge of the information that is available. 

With agriculture these characteristics are fairly obvious. There are a very large number of farmers, Farmer Smith’s corn is pretty much identical to Farmer Jones’, and buyers and sellers of corn know all that is important to know about the market for corn. With financial markets we have these same characteristics – more or less. There are lots of buyers and sellers so everybody is a price taker (however, there are some exceptions because large institutional investors such as mutual funds and pension plans can impact the price), buyers and sellers have access to the same information about a particular stock (such as financial statements, macroeconomic data, and industry statistics), and the product investors are after (the return on investment) is pretty much homogeneous (a risk adjusted 10% return in stock X is the same as a risk adjusted 10% in stock Y).

 

A big hot-button issue in finance is whether or not it is possible to create a portfolio of stocks that returns more than the investor would have received had he simply purchased every stock in the market. By buying all of the stocks, there is no need to study financial statements, forecast cash flows, and analyze macroeconomic data. You just buy them. If you do spend hours doing all that analysis and you don’t do any better than the market averages, you pretty much wasted your time (unless analyzing stocks is something you do for fun) 

 

Typically, we use the Standard and Poors 500 index as a proxy for "all of the stocks”. So, if the S&P 500 returns 12% and your portfolio returned 14%, congratulations! You beat the market. Virtually all portfolio managers can beat the market now and then but almost nobody beats the market over the long haul. Why not?

 

Just as wheat farmers receive what the wheat market has to offer, on average, portfolio managers receive what the stock market has to offer. This is because over the long term, financial markets process information fairly accurately (in finance lingo, the market is efficient). So, even though the markets can have severe short-term fluctuations, ultimately stock prices will gravitate to their true intrinsic value which leaves little opportunity to find mispriced stocks to be exploited for economic gain (during these short-term fluctuations it is not uncommon to beat the market – but whether this is skill or luck is tough to determine)

 

Years ago, Wall Street Journal reporter John Dorfman started a weekly column in which he pitted portfolio managers against a portfolio chosen by throwing darts at the financial pages. Over the ensuing months, the pros were about even with the forces of chance -- with the darts holding a slight edge. Amazing! All that work and research and all you can get for it is a return that is no better than throwing darts!

 

It is important to state that this does not mean that financial analysts and portfolio managers are dumb. To the contrary, some of the brightest people around go into this field. It just means that the financial markets are extremely competitive. Much like athletics, you may have a super star dominate for a while but eventually the competition catches up and ends the hot streak. In the financial markets there are thousands of professional investors (and thousands more amateur investors) who have the same information, which means nobody has a clear advantage and it is unlikely that any one investor or portfolio manager will beat the others consistently over the long haul. The only information investors don’t have is news events and since the news is unpredictable, so are the markets. Although there are many in the investment field who insist that they can beat the market, the evidence is that they can’t, UNLESS… 

 

I can’t end this without telling you that there is a way to beat the market EVERY TIME! Unfortunately, if caught you go to jail. It is called insider trading. If you are in possession of information that you know to be non-public AND know that the information would have an impact on the stock price if it were public, you are in violation of the law if you trade on that information. In this case, information has become ASYMMETRIC, that is one party to the transaction knows more than the other. Asymmetric information changes everything and we are no longer operating within the realm of competition.

 

The reason insider trading is such a serious issue is that if it becomes generally believed that the only way to make money in stocks is to know somebody on the inside (company executives, investment bankers, etc) people will keep their money out to the markets and this will make capital investment more expensive as there will be less savings available for financing. The result would be slower economic growth and smaller gains in the standard of living. Unfortunately, it is difficult to prove what somebody knew and when they knew it. As a result, there are relatively few insider-trading cases prosecuted. 

 

In the following video, Princeton University economist Burton Malkiel (author of A Random Walk Down Wall Street) debates a reporter. Be sure to watch (nine minutes)  

 

Passive Versus Actively Managed Mutual Funds 

MM