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Market Efficiency - Winning in a Losers Game

Jelly Beans to Illustrate Efficient Markets

In an attempt to illustrate how an efficient market operates, a financial advisor began a client event by putting a jar of jelly beans on the welcome table, and asked each of the attendees to write down 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 (including at an event I attended last year) 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 net of their fees.  

In 2018 alone, the daily average dollar volume of trades in global equity markets totalled $462.8 Billion.  With each trade, buyers and sellers bring new information 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.  

This doesn’t mean that a price for a stock or a bond is always right—there’s no way to prove that.  But, if you don’t believe that market prices are good estimates—if you believe that the market has it wrong—you are pitting your beliefs and hunches against the collective knowledge of all market participants.  Every day, managers of active mutual funds carry this belief as they try to beat the market through individual stock selection and market timing.

Winning in a 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.  

Charley again:

"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."

Actively Managed Landscape in Canada Today

Every year, Standard and Poors puts out a scorecard that ranks actively managed mutual funds against their chosen index benchmark.  

The results reflect that active management is, in fact, still a losers game in Canada.  

Across nearly all time horizons, the vast majority of actively managed funds fail to outperform their index benchmark.  In other words, historically speaking, if an investor simply bought an index fund which purchases all of the stocks or bonds in it's universe and keeping costs low - their funds' performance would have landed them in the top quarter or even top 10% of all of the investment funds over nearly all time periods.   This data suggests that while outperforming mutual funds do exist, identifying them successfully in advance is very difficult.

What to Do?

Despite these terrible results for actively managed funds, the majority of Canadians' individual retirement savings is still invested in actively managed mutual funds.   If you own bank mutual funds in your RRSP's and TFSA's, there is a very good chance that they are actively managed.

The good news is that there are alternatives.  

There are a number of advisors out there (myself included) whose investment philosophy is based on using globally diversified, low-cost, tax efficient index funds - otherwise known as evidence-based investing.  I combine low-cost investing with comprehensive financial planning and work mostly with families in the GTA.  If you want to get in touch and have a chat, you can contact me here.

If you prefer to do it yourself, there are plenty of great platforms out there that will let you choose your own portfolio of index funds, as well as a number of great resources to help you on your DIY journey.  

https://canadiancouchpotato.com/

https://rationalreminder.ca/

https://boomerandecho.com/

Charts provided by Dimensional Fund Advisors

Photo by Patrick Fore on Unsplash

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Content here is for informational purposes only.  Please consult with your legal, tax, and investment professionals before making any decisions based on this material.  Thank you.