In Seinfeld Season 9, Episode 3 - "The Voice", Elaine runs into her on-again-off-again boyfriend, David Puddy at Monk's coffee shop. They had recently broken up.
After Puddy leaves, Jerry explains to Elaine that she is destined to get back together with David. The "bump-in always leads to the back-slide", says Jerry before he delivers by far my favourite analogy for explaining one of the most important ideas in all of finance.
The global publicly-traded stock and bond markets are highly efficient information-processing machines that arrive at close-to-fair prices for the securities that trade on them every day.
This condition renders the pursuit of outperformance via stock picking and market timing to be futile for the vast majority of investors, individuals and professionals alike.
The most sensible investment strategy for the vast majority of individual and institutional investors is to build a portfolio of low cost index funds/ETF's and stick with it over the long term
What you just read is equal parts true, important, and nuanced. This makes it simultaneously the most important and the most difficult reality to explain to the uninitiated. But like you need to rock a pop machine back and forth a few times before it goes over, the best way to approach this is to use some examples and analogies to get the momentum going.
Jelly Beans to Illustrate Efficient Markets
I was at an event held by Dimensional Fund Advisors a few years back. The speaker began event by putting a jar of jelly beans on the welcome table, and asked each of the attendees to secretly write down and hand in their guess for how many jelly beans were in the jar. The guesses covered a wide range; from 409 to 5,365 jelly beans.
The average of all the estimates was 1,653 jelly beans. The correct number was 1,670.
Individually, each of the people at the event applied their own logic and reasoning to the problem and made their guess. Individually, their guesses may have been good or bad. But, as more an more people made their guesses, the collective knowledge of the group came together and became more powerful than the knowledge of one person.
This experiment has been repeated over and over again and the results come out the same every time.
Are stock and bond markets efficient?
In the same way that a large group will effectively guess the number of jelly beans in a jar - the same phenomenon exists in public markets for stocks and bonds around the world. The idea being, that the more players you introduce to the competitive game of stock and bond picking, the tougher it is for any of the skilled players to beat out the competitors consistently.
In 2020 alone, the daily average dollar volume of trades in global equity markets totalled $653.8 Billion. With each trade, willing buyers and sellers are bring new information, insights, and expectations to the market, which helps set prices. No one knows what the next bit of new information will be. The future is uncertain, but prices will adjust very quickly to new information.
The idea that stock and bond prices reflect all of the knowledge and expectations of investors is known in academia as the Efficient Market Hypothesis, developed by professor Eugene Fama from the University of Chicago Booth School of Business.
Of course, the Efficient Market Hypothesis is a model. It does not mean that all information is perfectly reflected in accurate prices for a stocks and bonds at all times. But, it can be a useful model for long-term investors to live by.
Will there ever be another .400 hitter?
Ted Williams was the last major league baseball player to hit .400. He did so in 1941, over 80 years ago.
Will anyone ever hit .400 again? I doubt it.
Is it because Ted Williams was a far superior player to today's players? No, in fact I believe that if Ted Williams were alive today and at his playing age, there is a good chance that he would not make a single major league roster. The reason is because the competition level among all major league players has risen tremendously since 1941. Training regimens, diets, skills, and advanced analytics and scouting have all come so far over the past 80 years. It's not that there aren't great players today, it's that it is hard to stand out like Ted Williams did when the level of competition has risen so dramatically across the board.
In other words, it's not how good you are that determines whether you will hit .400. It's how good you are relative to the competition you are facing every day.
(H/T to Russell Sawatsky for inspiring me with this great analogy)
Winning the Losers Game
Charles D. (Charley) Ellis is an American investment consultant, founder of Greenwich Associates, and former chair of the Yale University Investment Committee. In his book, "Winning the Losers Game", Charley Ellis, CFA describes the investment game as a losers game, where the best way to win is by not making big mistakes. Charley describes the state of the professional investment management world today in this way:
"Often, winners games self-destruct because they attract too many players, all of whom want to win....the "money game" we still call investment management evolved in recent decades from a winners game to a loser's game because a basic change occurred in the investment environment: The market came to be overwhelmingly dominated by investment professionals - all knowing the same superb information, having huge computer power, and striving to win by outperforming the market they collectively completely dominate. No longer is the active investment manager competing with overly cautious custodians or overly confident amateurs who are out of touch with the fast-moving market. Now he or she competes with hundreds of thousands of other hardworking investment experts in a losers game where the secret to "winning" is to lose less than the others lose, by enough to cover all the costs and fees."
Charley goes on to describe how in the mid 1900's, the stock and bond markets were still still a winnable game for institutions, where institutional investors could beat the market through stock selection. But back then, the market was dominated by individual investors who could be beaten by professional investors.
Charley called these people "willing losers". The professional investor with all of his or her insight, information, and expertise could beat out the unskilled amateur investor and beat the overall market after accounting for his or her fees.
But in recent decades, as recently as the mid 1970's, the pendulum swung wildly the other way - with professional investors like large fund companies, pensions, and endowments making up the vast majority of trading activity.
"Today's money game includes a truly formidable group of competitors. Several thousand institutions - hedge funds, mutual funds, pension fund managers, private equity managers, and others - operate in the market all day, every day, in the most intensely competitive way....thus, almost every time individual investors buy or sell, the "other fellow" they trade with is one of those skillful professionals - with all their experience, all their information, all their computers, and all their analytical resources.
"Sure, professionals make mistakes, but the other pros are always looking for any error so they can pounce on it. Important new investment opportunities simply don't come along all that often, and the few that do certainly don't stay undiscovered for long.
"That's why the stark reality is that most active managers and their clients have not been winning the money game. They have been losing. So the burden of proof is surely on the manager who says, "I am a winner; I can win the money game."
So in the same way that there will likely never be another .400 hitter, the stock and bond markets have become so competitive that it is approaching impossible for a professional investor to beat the market over long periods of time.
What are the Implications for Investors?
So if the market is mostly efficient, what are the implications for individual investors? Here are a few:
1. Index funds are the most sensible choice for long-term investors - Investors today don't need to choose an active fund manager or try picking individual stocks with their long-term investments. You can buy Index Funds and ETF's that invest broadly in Canada, the US, and Internationally - in both stock and bond markets. You can blend stock and bond ETF's together to match your goals and risk tolerance. In other words, instead of looking for needles in haystacks, you can simply buy the haystack. Over the 30+ years, this approach should outperform the majority of professional money managers, provided that you can stick with it for that long.
2. Timing the market is futile - Since markets already reflect the expectations of all participants, it is not reasonable to try and tactically move your money in and out of your investment portfolio to avoid a downturn. If you think we are heading towards a recession, it is almost certain that the prices of stocks and bonds have already shifted and "priced in" the likelihood of that event. Provided that your portfolio of index funds/ETF's is appropriate for your financial plan and risk tolerance, you just need to stay the course. Again, this is easier said than done so it requires discipline.
3. Risk and Return are Tied at The Hip - Intellectually, most people understand that risk and return are connected. For example, we understand that there is more risk owning a Canadian small cap stock ETF than there is owning a Short term government bond ETF. The stock fund is far more volatile than the bond fund. Therefore, we demand and expect a higher return for owning the stock fund than we do for owning the bond fund. This is an iron rule in investing. The efficiency of the public market makes it this way.
4. You can have a better investment experience - One of the best parts about accepting that the market is mostly efficient and investing accordingly is it allows you to have a much better overall investment experience. If you own a super-diversified, low-cost portfolio of index funds/ETF's you don't need to sit up at night wondering if you are in the right stocks, or if you should sell and get out of the market because you are worried about the next negative economic event. You can embrace the fact that the markets will rise and fall, that you "own the haystack", and that you have aligned your portfolio properly with your goals.
Explaining the theory of efficient markets can be a bit tricky and nuanced. Hopefully that pop machine is at least rocking back and forth a little bit, and that you can see its potential importance for your overall investment experience.
(Chart Source, Dimensional Fund Advisors)
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