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The Stock Market
Is Not A Casino

Stock returns are not driven by the random roll of dice but rather by the revelation of new information. Everybody has a little piece of the total. The function of the market is to aggregate and evaluate it. The prospect of speculative profits is the “bribe” society offers investors to speed the incorporation of the information into prices. Once the information is incorporated everyone benefits from having more accurate prices on which to base decisions. Most people might as well just buy a share of the whole market, which pools all the information, than delude themselves into thinking they know something the market doesn’t. - Merton H. Miller 1990 Nobel laureate in economics.

The Stock Market<br /> Is Not A Casino

Is it Possible to Beat the Market?

(Updated August 2020)


When it comes to investing people have lots of false-beliefs and misunderstandings are common. The investment investment management profession has traditionally been rooted in the notion that superior skill in market timing and security selection can beat the market. Investors’ misconceptions and wishful thinking often support this hypothesis given their desire to find money managers willing to assure them of superior results. The financial press adds to the controversy because it thrives on writing articles that in one way or another feed the notion that are ways to beat the market.

Because the stakes are high and the potential rewards are great it’s no wonder that many bright, talented people are drawn to the profession. Ironically, it is because of the intelligence and skill of investment professionals engaging in these activities that the probability for success in these areas is so low. Imagine a single securities transaction. The buyer has concluded that the security is worth more than cash, while the seller has concluded that money is worth more than the security. Each have carefully evaluated all publicly available information concerning the asset and have reached opposite conclusions. At the moment of the trade, both parties are acting from a position of informed conviction, even though time will prove one of them right and the other wrong.

For instance, one investor may believe an excellent earnings report from Apple makes the stock a buy; another may feel that the stock has nowhere to go but down the following quarter. This example is repeated millions of times daily in markets around the world. Stock picking experts and research analysts compete aggressively to find stocks they believe to be over or under-valued to trade for profit. But in a free market their transaction price is a consensus of a security’s intrinsic value. This is nature of an efficient market.  And in an efficient market it’s difficult to imagine that a security’s market price will depart meaningfully from its true underlying value.

The efficient markets hypothesis (EMH) is the organizing principle for understanding how markets work and what investors should care about. Professor Eugene F. Fama of the University of Chicago performed extensive research on stock price patterns. In 1966, he developed the efficient markets hypothesis, which asserts that:

•Securities prices reflect all available information and expectations
•Current prices are the best approximation of intrinsic value
•Price changes are due to unforeseen events
•Stock prices follow a random walk and are not predictable
•Although stocks may be mis-priced at times, this condition is hard to recognize.

In other words, an efficient market incorporates into current security prices relevant known information as well a consensus expectation regarding the unknown. The most important premise of the efficient market is not that new information is disseminated rapidly but that not all traders translate new information in the same way. If new information is the main driver of prices, only unexpected events will trigger price changes. This may be one reason that stock prices seem to behave randomly over the short term.

No matter how powerful a trader’s analytical tools, or how sophisticated their understanding of the industries they study, or how deep their knowledge of consumer and market trends, the fact remains that it is virtually impossible for traders to beat the market by gathering and analyzing information. The corollary to this notion is the expectation is that most active money managers, with their associated direct and indirect transaction costs, will underperform the market over time.

If professionals with virtually unlimited resources cannot apply research and analysis to pick winning stocks, it is even less likely that individuals can outperform the market. The futility of speculation is good news for the investor. It means that prices for public securities are fair and that persistent differences in average portfolio returns are explained by differences in average risk.

Market efficiency does not rule out the possibility that some money managers will earn above-normal returns. Over any period of time, some investors will beat the market, but the number of investors who do so, will be no greater than expected by chance and not without accepting increased risk. Without realizing this, many investors continue to compare their performance against the results achieved by the latest investment guru. In the end, investors often chase those performance numbers by constantly reallocating money from one manager to another as the search goes on for the elusive money manager who will produce the same superior performance tomorrow that was produced for someone else yesterday. Even in those rare situations where a money management organization has a unique proprietary insight that enables it to produce a superior result, the expectation is that the advantage will be eroded over time as other money management organizations discover and exploit the process.

Challenges to Efficient Market Theory

The efficient market theory has been repeatedly challenged. After all, some stock pickers do quite well by following a specific strategy or investment discipline, which suggests that the market can be outsmarted. But the real test is whether any active investment strategy can consistently beat the market over a long period of time. As studies point out the number of funds outperforming the market is no greater than one would expect by chance.

From the perspective of Ken French, the tendency of past winners to keep winning and past losers to keep losing relative to their peers is one of the biggest challenges to efficient market theory. French argues that it’s hard for active managers to take advantage of stock price momentum because it’s a high turnover strategy and the transaction costs probably consume the potential gain.

Other investing methods that cast doubt on the idea that markets are efficient include seasonality strategies such as the “January Effect” and “Sell in May and Go Away”; the Dogs of the Dow approach; and the Dividend Yield and the PE-indicators. These strategies and others like them attempt to determine the future price of stocks based on market timing or specific characteristics of a stock or group of stocks. How do investors know whether a pattern is genuine or occurs by chance? The best way to verify whether a pattern is genuine and not driven by back-test bias is to look at out-of-sample statistical evidence. This evidence demonstrates that none of these strategies has yielded long-term market-beating results, and all require investors to take on greater risk and higher costs than the passive alternative.


What about Stock Market Bubbles?


Market behaviorists suggest that the internet bubble that burst in 2000 and the market crash of 2008 were signs that the market is not efficient. That is, the market was irrational and did not drive stocks to their proper valuations. However, based on all available information, the prices seemed fair and current trends looked like they would continue. “I’ve heard too many people who knew well before it happened that the 2008 financial crisis was inevitable”, says Daniel Kahneman in wonderful new book, Thinking Fast and Slow (2011). In his words, "some people thought well in advance that there would be a crisis but they didn't know it. They now might say they knew it, and claim credit for insight they do not deserve, because a crisis did in fact happen.


Only in retrospect did the tech bubble and the housing crash seem predictable and inevitable. When these markets crashed, it was clear that most forecasters were wrong. The money management industry would like you to believe differently so they can charge you more. One of their tricks is to make gurus out of the chance few managers and pundits who outperformed the market in the prior period or made a legendary market timing call. Unfortunately, there is no systematic way to repeat that performance.


Several studies have demonstrated that active management performance is remarkably similar to the random chance of a coin-tossing contest. In other words, it is luck, not skill that makes the difference. If this were not the case, many more active funds would not only outperform the market, but continue to do so year after year. But the winners are an ever-changing group, and the longer the time frame the greater the likelihood that an active investment manager will underperform the market. It beats common sense why so many investors continue to believe they can choose a strategy that can beat the market over the long-term.




The tremendous growth in the use of index funds serves as tangible evidence that money management today is being transformed away from attempts at market timing and stock selection to  the wider and more important context of asset allocation and diversification. Rather than trying to out-research other market participants, passively managed index fund investors look to asset class diversification to manage uncertainty and to position for long-term growth in the capital markets. The goal is no longer to beat the market but rather to devise appropriate long-term strategies that will move investors towards their financial goals with the least amount of risk.  These strategies do not fight the capital markets so much as they intelligently ride with them.


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