No Crystal Ball

Phi Kappa Phi Forum, Fall 2003 by Chambers, Larry

Today's "state-of-the-art" investment advice has been built upon a basic flaw - a shortcoming that causes investors to fail over and over again. That flaw is the concept that someone can predict the future. In fact, the entire securities industry thrives on this erroneous concept by focusing on past performance.

This belief system supports the sale of individual investment products and the competition for investable assets by funds. The people who work on Wall Street put together a good rationale for their stock picks, but the stock market is like the game of golf: it will humble anyone.

The stock-market pricing system is a vast information-processing machine that registers the implications of all available information. You may not know the information directly, but you have the implications of it in the set of market prices. When you make an investment decision by looking at stock-market prices, you are essentially saying: That price contains all the information of investors everywhere all over the planet. You do not need to spend too much time questioning the validity of the price; you are using approximately six billion times the information that you, individually, possess.

EFFICIENT MARKETS

The previous paragraph is an oversimplified example of "efficient markets," a phrase coined in 1965 by Eugene Fama, a University of Chicago professor. Fama's efficientmarket theory is probably the most misunderstood hypothesis in economics. It asserts that prices are probably wrong, and that they are right only on average. In other words, the amount that a stock is over- or underpriced is purely random.

When markets are efficient, it is because information moves rapidly and prices immediately reflect new information. Efficient also means that the prices reflect the knowledge and expectations of all investors. That way, no person can consistently know more about any individual security than does the market as a whole. The only condition necessary for market efficiency to occur is that nobody systematically profits more than could be expected by chance at the expense of other investors (as long as no one cheats).

Once researchers were able to get their hands on the earliest computers, they confirmed that asset prices did behave in a purely random fashion. They proved beyond a doubt that no one can forecast what is going to happen next.

It is ironic, then, that the most competitive sector of the economy, the financial-service industry, is designed to give advice based on the belief that the very markets they trade in do not work. According to Wall Street's view, stock prices react to information slowly enough to allow some investors, presumably professionals, to take advantage of market inefficiencies. But as good as Wall Street pundits think that they are, given all the available information, they still do not know where or when it is going to be inefficient. No evidence exists of any large institution having anything like a consistent ability to get in when the market is low and get out when the market is high; attempts to switch between stocks and bonds, or between stocks and cash, in anticipation of market moves, have been unsuccessful much more often than they have been successful.

But we still find that all traditional Wall Street-investment advice involves forecasting some future event, such as interest rates, the Federal Reserve's action, or whatever is in the media that day. Then, investments are made in anticipation of this action, and the portfolio is actively traded in an attempt to react to the accuracy of the forecast. It is then regularly modified as new information enters the picture. The media have taken advantage of this and have built an industry over this same flaw.

Money managers on Wall Street believe that the stock market is not priced correctly and that they can exploit the mispricing, or by buying the stocks before anyone else finds out then selling them for a profit.

The research departments of these Wall Street firms and media experts then try to guess which way interest rates will go, or which industry or sector of the market will "be in favor" over the next six months to a year. In essence, they all are simply telling the public that their "crystal ball" is better.

How does this misinformation get validated? Because every once in a while, someone like Warren Buffett or Peter Lynch shows up as having done an extraordinary job of picking stocks. Of course, you do not hear about them until after the fact. In the same timeframe, thousands of other investment managers did not come close to beating the market. But, investors are still desperately seeking the next Peter Lynch to guide their decisions - someone else to take responsibility for the guesswork.

Here is the part most investors do not understand: For an active money manager or broker to succeed, the markets must fail to correctly price an individual issue of stock, and that manager or broker must identify the mispricing and act on that information before it is corrected. The problem is, no one can consistently do it!