Consider the questions people ask us upon learning that we are a financial advisor. “What stock should I buy?” is a common response. They want to know if we can help them discover the next Apple. Another frequent request is, “Where do you think the market is going?”
They want to know if now is a good time to be invested in the market, or if they should bail out of stocks instead. If you have no answer, then surely you know a hot money manager or can identify the next Peter Lynch for them.
All these questions share something in common—we are being asked to make a forecast! Therefore, conventional thinking seems to be that, in order to have a successful investment experience, you must look into your crystal ball and predict the future. This is not the case.
2) Market Forces
There is a completely different approach that all investors should at least be aware of, and it wasn’t developed by the big banks and brokerage firms on Wall Street. It originated and evolved in the halls of academia and is based on a mountain of evidence showing that free markets work because the price system is a powerful mechanism for communicating information.
As F. A. Hayek pointed out in his Nobel laureate lecture, “we are only beginning to understand how subtle and efficient is the communication mechanism we call the market. It garners, comprehends and disseminates widely dispersed information better and faster than any system man has deliberately designed.“1
What does this mean in the realm of fiercely competitive capital markets? Simply, that prices are fair. Competition among profit-seeking investors causes prices to change very quickly in response to new information, and neither the buyer nor the seller of a publicly traded security has a systematic advantage. Therefore, the current price is our best estimate of fair value.
3) Just My Opinion
Despite the strength of market forces, many investors may never lose the urge to form an opinion about the future, or to ask their advisor for one. However, if an advisor chooses to offer an outlook for the future, it should be followed by a reminder that she doesn’t make investment decisions based on an opinion—hers or anyone else’s. If the compulsion to act on an opinion is too difficult for your investors to resist, ask them if it is conceivable that they are the only one with the information upon which their opinion is based.
If the answer is no and the information is widely known, then why wouldn’t it already be reflected in prices? For example, the claim that “everyone knows interest rates are going up” should be met with the fundamental premise that if the statement were literally true, rates would have already gone up! The logic behind how markets work is a formidable response to any forecast of the future.
4) Man vs. the Market
Not only is this logic formidable, but the evidence supporting it is also compelling. If free markets fail, it would be easy for investors to systematically beat the market, but in reality, man versus the market isn’t a fair fight and most of us should accept market forces rather than resist them. There is a large literature devoted to analyzing the results of professional money managers. It dates back over four decades to the original study of its kind conducted by Michael Jensen in 1968.
The experiments have been repeated many times with better models applied to larger and more reliable data, but the results continue to confirm the original conclusions. As you’d expect, some managers are able to beat the market on a risk-adjusted basis, but no more than you would expect by chance.
Furthermore, it must be the case that, in aggregate, investors earn market returns before fees. This doesn’t just hold over the long run, but at every instant due to the adding up constraint. The market reflects the collective holdings of all investors, so the value-weighted average investment experience must be the market return minus fees and expenses. This is not just a theory; it is a universal unconditioned truth relying solely on simple arithmetic.
This arithmetic leads many investors to think that, since money managers aren’t like children from Lake Wobegon (who are all above average), a winning investment strategy attempts to identify above-average managers and avoid all the others. But can you systematically identify in advance managers who will outperform the market after adjusting for the risks they took? Although it is hard to imagine there aren’t skillful managers, the challenge facing investors is that true skill is hard to distinguish from pure luck.
Identifying managers who have outperformed in the past is just as easy as looking up the scores from last night’s sporting events, but there is very little persistence in the performance of managers and no documented way of determining who will outperform in the future. Most regulators require sales communications to contain the disclaimer that PAST PERFORMANCE IS NO GUARANTEE OF FUTURE RESULTS with good reason. Regrettably this warning sign is treated like a posted speed limit and dismissed with flippant regularity.
This doesn’t mean professional money managers are stupid! There are undoubtedly many smart ones who take their job very seriously and work hard to get the best results they can for their clients. But the market is hard to beat because there are so many smart managers—and not in spite of it. If you take the world’s greatest bass fisherman to a dry lake, he won’t catch any fish. He’s still the world’s greatest bass fisherman, but that’s beside the point if there isn’t anything to catch.
5) Everyone Can Win
It is not necessary for someone to have a lousy investment experience for you to have a successful one. Everyone can win because with capitalism there is always a positive expected return on capital. The expected return is there for the taking, and as a provider of capital, you are entitled to earn it. That doesn’t mean it’s guaranteed to be positive, but only that it is always expected to be positive.
Realized returns are uncertain because the market can only price what is knowable. The unknowable is by definition new information. If it is considered bad news, or if risk aversion increases and investors require higher expected returns, then prices will drop.
This is the market mechanism working to bring prices to equilibrium where, based on the new information, the expected return on capital remains positive and commensurate with the level of risk aversion in the market. The opposite would be true if the new information is considered good news or if risk aversion declines. This is how well-functioning capital markets maintain a strong and pervasive relationship between risk and expected return. There is no free lunch.
The helpful comments of Eduardo Repetto are gratefully acknowledged.
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