“I’d be a bum on the street with a tin cup if the markets were always efficient.”
I believe in exceptionalism.
Most investing wisdom these days tell you that you can’t beat the market, that you should just stop trying and put your money in index funds.
For most people, average works just fine. In my view, though, aiming for average investment returns through passive investment vehicles is not good enough. Compound interest and the average market return of 10% may eventually lead to significant wealth over time, but it will take many years for that to become a reality. Your heirs will someday thank you for your prudence.
If you’re committed to putting the time into becoming a great investor, controlling your emotions and developing a viewpoint that differs from conventional thinking, you can do much better than average. Not everyone agrees with me, though, and much has been made of academic theories and hypotheses that show that most investors don’t beat the market.
The prevailing theory driving index funds and robo-advisors is the efficient market hypothesis (EMH, or EMT for efficient market theory). The theory posits that all available information is already priced into stock prices, thereby making stock-picking a losing game and fundamental or technical analysis irrelevant. Any advantage in the market is therefore derived solely from insider information.
Warren Buffett laughs at the efficient market theory. If the markets were indeed efficient, there would be no way he could have achieved his success by buying businesses or stocks that the market undervalued at the time. In a 1988 letter to Berkshire Hathaway shareholders, he wrote:
Naturally, the disservice done to students and gullible investment professionals who have swallowed EMT has been an extraordinary service to us. In any sort of a contest — financial, mental, or physical — it’s an enormous advantage to have opponents who have been taught that it’s useless to even try. From a selfish point of view, [we] should probably endow chairs to ensure the perpetual teaching of EMT.
Though he has slammed EMT in the past, Buffett has recently recommended index funds for average investors and admitted that his estate will be put into index funds. My interpretation is that he is suggesting that most people don’t have the time or inclination to manage their portfolios. Therefore, they are better served by placing their money in a low-fee, passively managed index fund than paying fees for an actively managed mutual fund that may or may not beat the market (and most likely won’t, after fees and taxes).
It’s no secret that fees cut into an investor’s total returns. Brokers want you to trade more so they make more commissions, regardless of whether or not you make money on the trade. With a range of options now available for the individual investor to trade for free, an investor can significantly minimize their fees and maximize their potential returns.
“I came to the conclusion that basically all our views of the world are somehow flawed or distorted, and then I concentrated on the importance of this distortion in shaping events.”
Mark Tier’s excellent 2005 book Becoming Rich: The Wealth-Building Secrets Of The World’s Master Investors Buffett, Icahn, Soros expertly breaks down the investing habits used by the best investors. One chapter called “The Market Is Always Wrong” (a quote attributed to George Soros) examines how Soros, Buffett and Philip Fisher utilized contrarian viewpoints to achieve extraordinary results.
I was fascinated by Soros’ philosophy, specifically that everyone’s viewpoint is flawed, including his own. Despite whatever successes you may have and no matter how many hunches and intuitions you guess right on, you will eventually be wrong.
Too many people are done in by overconfidence. After several good calls, they may think that they can’t lose and will hold on to a bad investment for too long or sell a good one too late. As Baron Rothschild once said, “I never buy at the bottom and I always sell too soon.”
Soros says that “what beliefs do is alter facts” and discussed this in his book The Alchemy Of Finance. He calls this “reflexivity,” similar to a feedback loop or an echo chamber.
Let me try to explain: Tilray is the hot stock at the moment, and the market has dramatically driven up its share price on the belief that the cannabis sector has limitless growth potential. The frenzied speculative trading of the stock over the past few weeks has caught the attention of analysts, who then upgrade the stock. This drives the stock up even further, and so on and so forth.
This boom cycle is unsustainable and the stock must eventually falter. By looking over the underlying fundamentals and seeing that there is no legitimate reason for the frenzy, an adept contrarian investor might consider shorting the stock to try to cash in on the resulting bust.
People are ruled by emotion and are not always rational. The efficient market theory might work well in a computer simulation, but inefficiencies are everywhere in the real world and can be capitalized on. September 11th or the October 1987 market crash are black swan events that no academic or economist can accurately predict and defy the efficient market hypothesis.
The market concentrates too much on short-term profits and ignores long-term thinking. Over the long-term, I do think that the market eventually becomes efficient as fundamentals get taken into consideration. In the short-term, overreactions to quarterly profit misses or headline news cause great opportunities for the savvy investor to capitalize on temporary market inefficiencies.
I believe in exceptionalism. With ingenuity, patience and devotion, an exceptional investor can beat the market by not taking huge risks and by being an investor rather than a trader.
The market is always wrong — use that to your advantage!
Disclosure: The author owns shares of BRK.B