The Miracle of Stock Market Efficiency
Sorry, There Is No Santa Claus
Posted Apr 29, 2012
OK, you would like to know the most profitable stock market investment strategy. Naturally, a question of such magnitude has already been investigated. Numerous researchers have done scientific studies on that very issue over the last four decades. The results have been consistent, in fact overwhelming. The answer is known as well as anything can be known. The answer is: No investment strategy has ever been found that outperforms the simplest possible approach of buying and holding a market portfolio. ("Market" portfolio means a diversified cross-section of the stock market, e.g., the S&P 500, or a randomly selected portfolio.)
No alternative strategy has been found to match or exceed the returns offered by just buying and holding a diversified portfolio of stocks. No other trading strategy such as attempting to buy low and sell high, or trying to time the market, has bettered the simple buy-and-hold approach. Another way of expressing this, based on evidence: Of all the professional stock pickers and money managers at investment companies, the number who outperform the market, i.e., the average of the S&P 500, is fewer than would occur by random chance. In other words, if the entire investment community abandoned their methods and instead made stock selections by throwing darts blindfolded at the newspaper listings (or by hiring chimpanzees to do the same), their performance, collectively, would be better than it actually is. If you were to buy stocks at random by throwing darts, there is a chance―random chance―that you would earn a return higher than the market average. The number of investment professionals who do beat the market is far lower than it would be if they all did it by random selection. Therefore, the rare exceptions who outperform the market average cannot be attributed to anything but chance, i.e., dumb luck. Then those (e.g., mutual funds) that do exceed the market in a given period may be underperformers in the next period. This is the explanation for apparent counterexamples you may think you are aware of. (Can we be sure there isn't one person or mutual fund somewhere that genuinely beats the market average by skill and judgment, rather than by chance? No, but as long as the number of investment managers who do is less than would happen by chance, it is pointless to make that assertion.)
The main reason for this inability of judgmental or managed investment strategy to do as well as the most naïve buy-and-hold strategy is what is known as market efficiency. The stock market has been found to be an efficient processor of all available information, so stock prices always contain and reflect that information. Market prices are fair, in other words. It is not possible to gain over the long-run, therefore, by selling one stock in order to buy another, i.e., "trading." If you purchase a favored stock because you think its price is too low relative to its value, and sell a non-favored one thinking its price is too high (overvalued), you are equally likely to lose as to gain, relative to your return had you not made the trade. The market's efficient pricing mechanism ensures this outcome―over the long run―because its fair prices, which fully reflect all available information, make it equally likely that any single stock issue will return more or less than the market. Also contributing to the investor's demonstrated inability to beat the market average are transaction costs. If the probable future returns of two investments, a stock you favor and one you don't, are actually the same (i.e., each is equally likely to outperform the other) regardless of what the stock trader thinks at the time, selling one to buy another will be a losing event relative to "buy-and-hold" because of trading costs such as commissions and taxes.
Such a mountain of evidence supports this "efficient market" position that it is widely believed to be more evidence than supporting anything in any other field of study, or at least any field having to do with human behavior. Confirmed exceptions to this efficient market principle are rare: (1) genuine insider information, usually illegal to act upon, which is not publicly available and allows the possessor of it to gain an edge; (2) selected inefficient markets. Major exchange markets for stocks, bonds, commercial paper, commodities, and so forth are considered efficient, so all the above applies. Some markets, such as those for local residential real estate or collectibles, might not be efficient in the sense described, so "all bets are off" for them and there may exist opportunities for above-market returns.
But how does buy-and-hold strategy square with the “bear” market or crash of 2008? Wouldn’t you as an investor have been better off if you had gotten out of stocks at their peak in 2007? Sure, but this does not invalidate the efficient market principle or buy-and-hold strategy. You see, investment decisions have to be made prospectively, not retrospectively. They have to be made in advance, not with the benefit of 20/20 hindsight. Of course, if you knew in advance that the stock market would tank, you could act on that knowledge. But no one knows in advance―although some think they do.
OK, what if you did predict the 2007-08 bear market, or the 1987 Black Monday crash, as some luckily did? (Underscore “luck.”) Good for you, but no matter to this principle. How many times did you think the market would go down, or up, and turned out to be wrong?
The problem is that you, the investor, must guess right at least twice in a row. That is, you also have to be right about which alternative investment (bonds, gold, whatever) to buy, or when to get back into stocks. And you can’t be right a high enough proportion of the time over the long term to offset the trading costs of commissions and taxes. And because of those costs, the return from such trading will be less than that delivered by random chance! Of course, historical results are not guaranteed to be duplicated in the future, but what I report to you is the best available evidence from the 1926-2012 period, along with the optimal strategy derived from it. Yes, you might lose if you buy and hold. But you are more likely to lose if you don’t.
As you can see, the way investing in the stock market really works is nothing at all like the general public thinks it works. It is much easier. According to the best scientific evidence, it is a no-brainer. Don’t blame me for revealing that there is no Santa Claus. Again, I didn’t make this up. It comes from decades of research in the field of financial economics.
For more ultimate answers, and surprising answers, on the subject of personal finance, see my book Frugal Cool, available at corbypublishing.com.