Can You Beat the Market?

On average, even professional money managers don't beat the market. Why not? It's not because money managers aren't smart. I know people in this sector, and they're very smart. Rather, it's a reflection of the power of market prices to quickly reflect available information. This leads us to Investment Rule #2: "It's hard to beat the market."

First, let's consider some possible investment advice. You've probably heard that the American population is getting older -- and that's true. The number of people aged 86 and over, for instance, is projected to increase dramatically over the next several decades. To profit from this coming aging you might think, well, you should invest now in products that the elderly will want or need, such as nursing homes, pharmaceutical firms, and companies that make reading glasses.

That's good advice, right? Well, no, not actually. What I just said was useless investment advice. Why? It's useless because the aging of the U.S. population isn't a secret: it's public information. And so, the value of that information is already incorporated in stock prices. Suppose, for example, that you took this investment advice and went out and bought some shares in a firm that manages nursing homes. For every buyer, there's a seller.

Why is the seller of those shares selling? Doesn't the seller know that the American population is aging? Of course, that's known! And so, the price already reflects this public information about the aging. So, don't expect to make extra profits based on public information. In other words, if your theory of why a trade is going to be really profitable is that the person on the other side of the trade is dumb.

Well, that's usually a bad theory. Maybe you're the dumb one. This idea is the foundation of what is called the Efficient Markets Hypothesis. The prices of assets, such as stocks and bonds, reflect all publicly available information. And that means, if you're investing based on that information, you won't be able to systematically out-perform the market over time. Think about it this way: on average, buyers have just as much information as sellers, and vice versa. So that means a stock is just as likely to over-perform the market as it is to under-perform. That's why Burton Malkiel called his book, A Random Walk Down Wall Street.

In fact, the mathematical models used by economists to understand the motion of stocks and stock returns are the same models developed by Einstein to explain Brownian motion: the jittery random movement of small dust particles as they're bumped into and buffeted about by atoms and molecules. Stock returns are hard to forecast because old information is already incorporated in stock prices, and new information is by definition unexpected, or random.

What if you've got a hot stock tip? Can you then beat the market? It's still highly doubtful. New information comes to be reflected very quickly in prices. Here's an example: At 11:39 Eastern Standard Time on January 28th, 1986, the space shuttle Challenger exploded in a great tragedy, killing everyone on board. Eight minutes later, that news hit the Dow Jones wire service. Things were slower back then before instant messaging. The stock prices of all the major contractors who had helped to build the shuttle, such as Morton Thiokol, Lockheed, Martin Marietta, and Rockwell International, all fell immediately. Now here's what's really interesting. Six months after the disaster, a commission was set up to investigate the cause, which turned out to be the failed O-rings made by Morton Thiokol.

Now let's return to the day of the crash. On that day, Lockheed, Martin Marietta, and Rockwell International all fell by 2-3%, but the stock of Morton Thiokol fell by over 11%. The market had correctly figured out that Morton Thiokol was the most likely cause of the disaster, and within hours that information was reflected in market prices, even though a formal investigation had not yet begun. In essence, the people with the best knowledge about the likely causes of the crash could either trade themselves, or tell other people how to trade. And so, some investors started selling, and the price of the Morton Thiokol shares started falling, and that new and lower price was reflecting the new and lower value for the company. Now that was back in 1985. Nowadays, new information starts to change markets, not in hours or minutes, but in seconds or milliseconds -- literally faster than the blink of an eye.

Okay, now one important point before we conclude. Stock prices aren't pure random walks, but rather random walks with a positive upward drift. It's how well you do relative to the average market return, which is hard to predict. On average, investors can expect to make money over time, and in this sense, some broader general predictability is present. Okay, so Investment Rule #2 says you shouldn't expect to beat the market.

So how should you invest? That's the issue we take up next.