As a student of both economics and finance, I generally hang out in the econ world (in the blogworld) more that the finance world. However, I try to keep abreast of financial matters. I hold, generally, a long-term view towards investment themes. Economists often harshly criticize the investors (often investors in mutual funds). They use the “efficient market hypothesis” to accuse those that dabble in managed investments to be cavemen. These are men that are so foolish as to shed any notion of reason and science and spend a career trying to beat the market. And those, that are lucky enough to succeed (for given a large sample size, there are bound to be a select few who come out wildly on top) have the shameless ignorance and arrogance to proclaim their methods to be of skill rather than luck. Many studies, which show mutual funds are about as likely to beat the market as throwing darts at the WSJ, showcase this disdain.
My comments will express my great displeasure with any notion of a “super” efficient market hypothesis as well as give a general defense of the investing profession (no matter how barbaric these men might seem). There are many areas of finance, but I will concentrate on investing, specifically active management (versus say indexing). I will conclude that active investing is indeed a viable industry just like any other and that it holds great value for society, which is shown in the vast profits that some claim.
The efficient market hypothesis in its most extreme goes a bit like this. “All information is instantly factored into the markets through the great knowledge of the masses. Stock prices reflect current expectations of future profitability based on aggregate information across the entire world up to this second. Picking stocks, therefore, is a fool’s game because no one can know any more than anyone else. Game over—INDEX.” Now, I will come right out and say it. This is about the stupidest thing that I have ever been taught. I don’t think anyone who teaches it takes it that seriously, but I’m sure some do. I guess it’s more or less taught to make a point—to understand the underlying logic to much of portfolio theory (or underlying rationalizations).
But why the hell do we choose the stock market and assume it is perfectly efficient? Why not everything else? Where are the efficiency theories for making cars, or planting corn, or teaching at universities, or writing books, or any other activity that creates economic value? For example, we could reason, all the information for the market for making cars is known by all instantly. Therefore, no one has an advantage. No one has a better idea of what will make a better car in the future. The market just works by random guess, some happen to work, some don’t.
Well why the fuck does anyone get out of bed in the morning then? If no one can ever find advantage over anyone else, let’s just shut it down. Why should I waste the effort, when the effort doesn’t matter, and I will be just as likely to make a billion as to lose everything (actually much more likely to lose everything, since I don’t have near a billion to start with).
Oh but the stock market is the exception. Because SOOO many people are interested in it, and SOOO many people have their retirement futures involved it in, and SOOO many people make SOOO much money in it (never mind that this last statement is self-defeating). Therefore, this is the one place where we play God and know everything. The worst part of the theory isn’t the absurd proposition that everyone knows everything instantly. I think that I can reason around this a bit. The people that matter the most know a lot, and with the acceleration in the speed of communications know more and more every day. And these people have enough money that they can put the odds back in shape, by placing huge bets. And there are enough of them around the world to do it very quickly. So in the end, this thing sort of works out as if everyone has all the information instantly. I can follow this and see some sense in it. The real stupidity comes in when you take this to the next step. One reasons, if everyone has exactly the same information (all current information), then everyone will share identical expectations.
Expectations are what stocks are priced on. Sure everyone has the information, but everyone uses the information differently. Thus each individual may represent unique expectations given equal information. Resulting stock prices are the aggregation of these millions of unique expectations. And these aggregations hold great wisdom. Some look to this type of emergent intelligence to be much greater than the sum of its parts. No single human could compete with such a depth of information. And quite frankly, this is true. So once again, what are we doing? Are we simply slaves to the master of market, fueled by the ignorant bliss than an individual’s opinion matters?
It depends on what you are talking about. No lone soul could match the depth of the worldwide market’s knowledge, but individuals or groups of individuals can specialize. An investor can focus her knowledge on a relevant niche of expertise. And maybe this is why markets are so smart in the first place. In every little niche available there are experts that analyze their niche every day. They know it inside and out. The true experts are a small group of individuals. These people, it would stand to reason, have varying opinions, but with their equal depth of knowledge may have less variance of opinion than a larger group of, say, investors as a whole. When these experts see the scales tipping out of control they mobilize their capital and try to take advantage of it. But even within these expert groups some might be very good and smart and others not so good and stupid. The stupid ones could match the smart ones bets and keep the value distorted for long periods of time, until the stupid ones are knocked out. But you’ll notice that this cycle favors the smart ones and keeps increasing their pies, which leads to more accurately valued stocks. But smart ones don’t always stay smart, you must remember.
The greater point is this. Investing is fundamentally just like any other business. A new investor is analogous to the entrepreneur. The entrepreneur looks at a market and sees an investment that is under or over-valued and tries to correct it. People often call entrepreneurs crazy, saying: “There are already huge corporations with really smart people that have been studying this for years. They know way more than you. They know everything to know about this business. How could you do better than them?” Well like anything there are always tradeoffs. Sometimes when you are too close to a business or market you can exhibit tunnel vision. Giants are often blindsided by wild entrepreneurs with a new approach to tickling the customer. And how does this relate to investing?
The investor can specialize. Focus his efforts. Create new ways to invest. Look for different things to invest in. Or do the same thing that is already done but just better. The information barriers to entry diminish with the increasing speed and quality of communication. The real barrier to entry in investing is capital. But some investors are able to turn a little into a lot. Especially since when you have just a little you can focus it on a portfolio of your best ideas.
So this has been a broad, perhaps unscientific, defense of the investing profession. Investing is by no means easy. There is fierce competition. But with specialization, intelligence, and a logical approach some will achieve success—and not just for luck. The freedom a hedge fund manager often enjoys allows for the best structure to compete in investing. (But you need serious capital to start up one of these, not to mention reputation).
The real question is: are active managers successful enough to reward the extra fees versus indexing? How costly is it to choose the correct active manager? I think for the typical average Joe is indexing a good bet. But for with more expertise and wealth, you'd be a fool not to put a bit of your portfolio in a hedge fund or funds. That being said everyone has different circumstances and goals that may require different investments.