Why Is It Hard to Beat the Market?

These results aren’t just an accident. Nor is it a statement about the stupidity of mutual fund managers. We know a few of these managers and most of them are pretty smart. Rather, the difficulty of beating the stock market is a tribute to the power of markets and the ability of market prices to reflect information.

Think about it this way: For every buyer of a stock, there is a seller. The buyer thinks the price is going up, the seller thinks the price is going down. There is a disagreement. On average, who do you think is more likely to be correct, the buyer or the seller? Of course, the answer is neither. But if on average buyers and sellers have about the same amount of information, stock picking can’t work very well.

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Consider the following bit of pseudo investment advice. The number of senior citizens will double by 2020. So the way to make money is to invest in companies that produce goods and services that senior citizens want, things like assisted living facilities, medical care for the elderly, and retirement homes. The baby boom can be a boom for you, If You Invest Now! Sounds plausible right? So, what’s wrong with this argument?

All the premises in the argument are true: The baby boomers are retiring and the demand for goods and services that senior citizens want will increase in the future. But investing in firms that produce goods and services for senior citizens is not a sure road to riches. Why not? If it were, why would anyone sell his or her stock in these firms? Remember, for every buyer there is a seller. If you think the stock is a good buy, why is the seller selling? It’s not a secret that the baby boomers are retiring so the stock price of firms that are likely to do well in the future already reflects this information.

Since for every buyer there is a seller, you can’t get rich by buying and selling on public information. This idea is the foundation of what is called the efficient markets hypothesis. The best-known form of this hypothesis states:

The efficient markets hypothesis says that the prices of traded assets reflect all publicly available information.

The prices of traded assets, such as stocks and bonds, reflect all publicly available information. Unless an investor is trading on inside information, he or she will not systematically outperform the market as a whole over time.

Let’s be clear on what this means. It doesn’t mean that market prices are always right, that markets are all powerful, or that traders are calm, cool, and rational people. It just means it is difficult for ordinary investors (that probably means you, too!) to systematically outperform the market, again, unless a trader has inside information—information that no one else has. It’s restating our point that you might as well throw darts at the stock pages as try to figure out which companies will beat the market. The efficient markets hypothesis is just another way of saying there is no such thing as a free lunch.

So what happens if you do have some information that no one else has, then can you make money in the stock market? Yes, but you have to act very quickly. Within minutes of the news that the Russian nuclear power plant at Chernobyl had melted down, shares in U.S. nuclear power plant companies tumbled, the price of oil jumped, as did the price of potatoes. Why potatoes? Clever traders on Wall Street figured out that the disaster at Chernobyl meant that the Ukrainian potato crop would be contaminated, so they bought American potato futures to profit from the coming rise in prices. The traders who acted quickly made a lot of money, but as they bought and sold, prices changed and signaled to other people that something was going on. Quite quickly, the inside information became public information and the opportunities for profit evaporated.

The only way you can take advantage of information that other people don’t have is to start buying or selling large numbers of shares. But once you start the buying or selling, the rest of the market knows something is up. That is why secrets do not last very long in the stock market and that is another reason why it is so hard to beat the market as a whole.

Some people believe that they have found exceptions to the efficient markets hypothesis. For instance, it is commonly believed that you can make more money by buying stocks when prices are low, or by buying right after prices have fallen. That sounds good, doesn’t it? Buying at lower prices. It feels like what you do when you go to Walmart. But a stock isn’t like buying a lawn chair or a banana. The value of a stock is simply what its price will be in future periods of time. The banana, in contrast, you can simply eat for pleasure, no matter what the future price of bananas. Often lower prices mean that prices are going to stay low or fall even more and that means lower returns on owning stocks. Some studies find that you can do slightly better with your investments by buying right after prices have fallen. But do you know what? If you adjust those higher returns to account for the broker commissions that you have to pay for the extra trading, the higher returns pretty much go away.

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CHECK YOURSELF

Question 23.1

Is it better to invest in a mutual fund that has performed well for five years in a row or one that has performed poorly for five years in a row? Use the efficient markets hypothesis to justify your answer.

A field of study known as “technical analysis” looks for deep patterns in stock and asset prices. Maybe you’ve heard on the financial news that stocks have “broken through a key support point” or “moved into a new trading range.” If you dig deeper, you will find a claim that stock prices exhibit predictable mathematical patterns. For instance, if a stock hovers in the range of $100 a share but does not exceed that level, and one day goes over $100, it might be claimed that the stock is now expected to skyrocket to a much higher level. Hardly. One nice thing about studying the stock market is that there is a lot of very good data. One team of economists studied 7,846 different strategies of technical analysis. Their conclusion was that none of them systematically beat the market over time.3

For most investors, the efficient markets hypothesis looks like a pretty good description of reality.