Investors who rely on conventional wisdom can suffer as a result. In this column, I’ll identify some things about the stock market that “everybody knows” but aren’t so. Then I’ll illustrate how understanding what is so can improve your investment results.
The stock market discounts the future. This may sometimes be true for individual stocks, but it’s generally untrue for the stock market as a whole. It typically takes a year or more for trends in corporate earnings to be reflected in stock prices. The important lesson here is that we don’t have to worry about getting out in front of economic trends. Forget about watching CNBC every day, except perhaps for entertainment value. Trading in and out of the market may provide an adrenaline rush, but it’s not the pathway to wealth. Instead, focus on the hard corporate profit data—be in the market when profits are rising, which is most of the time. Lighten up or get out when profits stagnate or decline as happened from 1999 through 2001.
To achieve better returns, you have to take more risk. False. While stocks as an asset class have generated better returns while taking greater risk than bonds (for example), it’s not true that taking greater risks leads to achieving better returns. It is possible to achieve better returns from stocks while taking less risk and, as a general rule, those who take greater risk are likely to achieve lower returns.
Consider the following scatter plot. Pictured here are five-year returns and risk data for 11 widely held large-cap growth funds. Together, these funds hold more than $150 billion of investor assets. The five-year return and risk of the S&P 500 Index are shown as the dot in the center of the chart. Everything to the right of the vertical line running through the mid-point represents greater risk; everything above the horizontal line represents greater return. Most of the funds show up in the lower-right quadrant, representing higher risk yet lower returns. This pattern isn’t limited to growth mutual funds but can be observed in almost every category of stock portfolio over time. Rather than seeking ways to take more risk, look for ways to both raise return and lower risk by not following the crowd.
Markets are efficient. False as traditionally understood but true if properly defined. The traditional definition of the Efficient Market Hypothesis (EMH) is that at any given time, prices fully reflect all available information on a particular stock or group of stocks. According to the traditional EMH, no investor has an advantage in predicting stock returns since all market participants have access to the same information.
But how is “information” reflected in the market? The traditional EMH treats the stock market as a black box with myriad inputs for information. Somehow, magically, this information causes prices to move this way and that, depending on the nature and amplitude of the information.
But markets are simpler than that. The stock market is a clearinghouse for its participants’ opinions of value. How Joe Smith responds to the day’s news about GM has no bearing on its stock price if Joe is not in the market to buy or sell the stock even though he may react to information. But if Joe is in the market to buy or sell GM stock, his opinions about the company will affect the stock price, whether those opinions are rational or irrational, factually based or imagined.
Markets like the stock market are places where the participants exchange items of unequal value. Suppose Joe Smith just bought 100 shares of General Motors at $25 per share. This means he valued 100 shares of GM stock more highly than $2,500 in cash whereas the seller valued $2,500 in cash more highly than 100 shares. How much more Joe valued GM stock, or how much less the seller valued it, we don’t know—we only know they met somewhere in between their respective opinions.
If I were to redefine the Efficient Market Hypothesis, I’d say that efficient markets are those in which participants’ opinions regarding the meaning or importance of information are rapidly disseminated and reflected in prices.
It is opinion, not facts, that move markets. Over the past two decades, intense academic interest has been devoted to behavioral investing. Investors react to information in ways that are shaped not only by facts but by culture and how the human mind works.
One human characteristic in decision making that’s widely documented in behavioral investing research is known as “information cascades” or “rational herding.” People are more likely to make decisions based on how others make similar decisions than on rational processing of likely outcomes. The Internet stock boom of the late 1990s clearly illustrates the idea.
In buying and selling stocks, investors either overvalue or undervalue information regardless of its “true” meaning and value. Professor Jeremy Siegel points out in his most recent book, “The Future for Investors,” that taking the United States stock market over the past 50 years, investors have systematically undervalued the importance of dividends and overvalued that of growth.
To increase the chances of investment success, the wise investor discounts what’s popular. Instead, he or she examines past and current behavior of other market participants in an ongoing effort to identify what’s being overvalued and undervalued, making investment decisions contrary to the crowds operating on “what they know” that isn’t so.
This column is not intended as investment advice. You should consult your own adviser in determining whether to incorporate any of the opinions expressed here in your investment decisions.
