Why efficient markets are close to unbeatable, even for the pros

Wednesday Not-financial-advice Advice

People have been asking me for financial advice since I started trading equities right out of college.

I used to try to explain that being an equities trader doesn’t mean I know anything about investing, but that didn’t seem to put anyone off: I knew the difference between a stock and a bond, and I could tell a story about why they were going up or down at any given moment — and that seemed to be qualification enough.?

So I started giving people financial advice: Open a Vanguard account and buy an index fund.

Because one thing you learn as a trader is that markets are very close to random — and therefore?efficient.?

People see the wild swings in stock prices, the market bubbles and crashes, and the meme-stock rallies and wonder how anyone could ever believe that markets are efficient.

But that’s a misunderstanding of the term: The proof of Eugene Fama’s “efficient markets hypothesis” is not that stocks are always priced at their intrinsic value, as many seem to believe.??

It’s that stocks are priced such that future prices will be unpredictably random.

If you, like me, have tried both trading and investing over multiple cycles, you won't need to read the vast academic literature on the efficient markets hypothesis to know that it’s correct:

You’ll know from experience that it’s near impossible to outperform the market on any statistically significant time frame.

There is, of course, a giant industry of financial advisors, hedge fund traders, mutual fund investment managers, and investment bankers predicated on the idea that markets can be beaten.

But they rarely are.

Markets are not?perfectly?efficient, as even Fama concedes. So some traders and investors will do better than the index. But vanishingly few will do so consistently.

Still, it’s critically important that many more than a few think they can beat the market.

This is a paradox.?

Like voting in a federal election, where no individual vote ever makes a difference, but if no one voted, there’d be no democracy, no individual trader ever beats the market for long, but if no one tried, there’d be no market.?

If everyone thought markets were efficient, we’d all be fully invested in index funds and the price discovery that makes markets efficient wouldn’t occur.

Which is to say,?markets are only efficient because people think they’re not.

But I’m here to tell you they are: Buy an index fund.

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My advice is to not take advice

I should also tell you that I don’t buy index funds.

That’s not because I think I am one of the vanishingly few that will beat the market. I know that if I do beat the market, it will be luck.

Instead, I pick stocks because it’s entertaining.?

Watching the stock market with all your money in an index fund is like watching sports without a favorite team — it’s far more fun if you have a rooting interest.

Buying single stocks gives you a rooting interest in both the market and the economy.

If that’s reason enough for you to ignore my advice on index funds, then I have an additional piece of hard-won wisdom for you:?The best stock-picking advice is the advice you give yourself.

I don’t mean that in the sense of “do your own due diligence” (“DYODD,” as people on Twitter like to say): Pouring over balance sheets and reading 10ks is not going to unearth anything that the market is not already onto.

The market is “informationally efficient,” as Eugene Fama puts it (and much more so than when he coined the phrase in his landmark paper of 1970), so your goal is not to find information that others haven’t.

Nor is it to interpret public information better than the market has done — there are tens of thousands of professionals who do that full time. Hardly any of them beat the market.

Instead, your goal is to manage risk.?

My advice to take your own advice will help you do that.?

Because if you buy a stock on someone else’s advice, lots of other people will likely be in it for the same reason.?

And if that reason turns out to be wrong, they’ll all be selling at the same time, exacerbating the downside.?

You'll do better instead with your own advice because it will have approximately the same odds of being right (50/50, as markets are efficient), but a better risk/reward:?Being wrong on your own will have less downside than being wrong in a group.

And being right in a group will have less upside than being right on your own.

I, therefore, recommend you air-gap your portfolio by not doing anything you heard from someone else.

Are crypto markets efficient??

WisdomTree said ?in a filing yesterday that “the bitcoin market has matured such that it is operating at a level of efficiency and scale similar in material respects to established global equity, fixed income and commodity markets.”

That makes sense. Fama says the efficiency of a market is mostly a function of two things: the cost to trade and the availability of information.

?It’s cheap to trade bitcoin and, being fully transparent, its “informational efficiency” must be even higher than in equities.

So I imagine that your chances of being right or wrong in a bitcoin trade are something close to 50/50.

This logic does not extend much beyond bitcoin and ethereum, though: Once you get to altcoins, higher trading costs (via wider spreads) and less-accessible information (buried in Discord chats and private Telegram groups) would suggest that markets in the long-tail of crypto coins will be less efficient.

This is, counterintuitively, good news: It means that your crypto trades?might?have a better than 50/50 chance of being right.

But that is definitely not financial advice.

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