Who Is Your Competition?
Famed hedge fund manager Michael Steinhardt was once asked what the single most important thing an amateur investor could learn from him was. His arrogant but informative answer was “That I’m their competition.”
Every time you buy or sell a stock or mutual fund there is someone on the other side of the trade. So, apart from Michael Steinhardt, who is your competition when you invest?
Charles Ellis, in his classic investment book Winning the Loser’s Game, reports that in the 1950s and 1960s about 90 percent of stock trades were made by individual investors. Since then, due to the growth of pension funds, mutual funds, hedge funds, and ETFs, the equation has flipped. Now it is estimated that 90 percent of trades are made by investment professionals.
And who are these investment professionals? Most have graduate degrees from top business schools and they have survived a very competitive hiring process at some of the most respected companies in the country. They are the definition of “the best and the brightest.” In addition, they are provided with the latest technology, the fastest computers, and instant access to a wealth of information and data not available to the average investor.
In short, whenever you buy or sell a stock the person on the other side of the trade is most likely smarter than you, more experienced than you, and has resources you can’t match. Under these conditions it is almost impossible for you to beat the market.
The Efficient Market Theory
There is an old joke about a finance professor and a student walking across campus. The student sees a $100 bill lying on the ground and bends over to pick it up. The finance professor tells the student, “Don’t bother. If it were really a $100 bill it wouldn’t be there.” The joke is told to illustrate that it is not easy to beat the stock market.
The reason it is so difficult to beat the stock market is because your competition (all of the intelligent, highly motivated people working on Wall Street) make the market very efficient. This is known as The Efficient Market Theory, which is described by Eugene Fama as follows:
“In an efficient market, competition…leads to a situation where at any point in time, actual prices of individual securities already reflect the effects of information based both on events that have already occurred and on events which, as of now, the market expects to take place in the future. In other words, in an efficient market at any point in time the actual price of a security will be a good estimate of its intrinsic value.”
There just aren’t many $100 bills lying on Wall Street.
There is a lot of controversy in the world of finance about just how efficient the markets are. Obviously the markets are not totally efficient, but they are efficient enough to make it inefficient for you to try and beat them. As Larry Swedroe states “The market may not be perfectly efficient…. The prudent investment strategy, however, is to behave as if it were.”
If You Can’t Beat Them, Join Them
Beating the stock market has never been more difficult for the individual investor than now, but don’t despair. You don’t have to beat the stock market to be a successful investor. Simply matching the market can pay off very handsomely, and matching the market has never been easier or cheaper. It can be done using low-cost index mutual funds or ETFs, which allow you to stop competing with professional investors and join them instead.
We will learn more about index funds later. For now it is enough to admit that, over time, you can’t beat the stock market. So if you stumble on a $100 bill lying on the ground, go ahead and pick it up. Just don’t live your life staring at the ground looking for more. Use index funds instead and spend your time on more enjoyable pursuits.