Professor Gregory Mankiw recently wrote this article in the New York Times and opened with this:
OVER the last few weeks, as the stock market has reached new highs, my thoughts have turned to my 85-year-old mother.
"O.K. Mr. Smarty-Pants," she often asks me, "what stock should I buy now?"
A very fair question and, according to the article, one she has asked him many times over the past three decades.
He goes on to explain why economists tend to be not good stock pickers and, generally, why it's foolish for most to even try to pick stocks.
Here's part of his explanation:
"One prominent theory of the stock market — the efficient markets hypothesis — explains how answering my mother's question would be a fool's errand. If I knew anything good about a company, that news would be incorporated into the stock's price before I had the chance to act on it. Unless you have extraordinary insight or inside information, you should presume that no stock is a better buy than any other."
Well, he's certainly right that picking stocks over the long-term in a way that does better than the market isn't an easy thing to do.
Many who attempt to beat the market over the long haul by picking individual stocks do not succeed. The evidence is overwhelming in this regard.
So, for lots of reasons, too many participants tend to underperform and that's likely to continue. There would seem to be little doubt about that considering the evidence. As I see it, here's the problem and where the disagreement begins:
When someone -- I think it is fair to say -- rightly points out how difficult it is to outperform the market over the long haul, it seems the default primary reason offered is often the inherent efficiency of markets.
At first glance seems reasonable enough yet that, I think, is not just somewhat incorrect but, more or less, a grossly wrong conclusion.
The fact that so many participants underperform doesn't logically lead to the conclusion markets must be efficient.
Underperformance by a large proportion of market participants and inefficient markets can and do comfortably coexist.
Warren Buffett had this take nearly 30 years ago:
"I'm convinced that there is much inefficiency in the market. These Graham-and-Doddsville investors have successfully exploited gaps between price and value. When the price of a stock can be influenced by a 'herd' on Wall Street with prices set at the margin by the most emotional person, or the greediest person, or the most depressed person, it is hard to argue that the market always prices rationally. In fact, market prices are frequently nonsensical." - Warren Buffett
Charlie Munger added this back in 2003 when speaking at UC Santa Barbara back in 2003:*
"...Berkshire's whole record has been achieved without paying one ounce of attention to the efficient market theory in its hard form. And not one ounce of attention to the descendants of that idea, which came out of academic economics and went into corporate finance and morphed into such obscenities as the capital asset pricing model, which we also paid no attention to." - Charlie Munger
This is about criticizing what I happen to think has been and remains a very flawed way of thinking that just won't go away (or, at the very least, gain somewhat less influence).
This isn't about criticizing anyone in particular, and certainly not Professor Mankiw, who from much can be learned. I mean, it's inevitable to end up at odds on a particular idea. One disagreement -- though in this case a major one -- need not take away from the merits of all else someone has written or said.**
(Besides, though I do happen to have rather strong views on this subject, who says I've got it completely or even mostly right? Still, I do think that the idea that markets are efficient -- or that they are even mostly efficient -- will prove to deserve little respect. Best case, efficient markets and related ideas are just a flawed distraction but, to me, they seem to belong on a short list for the most damaging things to come out of economics and finance.)
This also certainly isn't an argument to buy individual stocks.
Quite the opposite.
John Bogle has it just about right when he says most investors would be better off buying index funds (and, in the article, Greg Mankiw notes that economists tend to follow that advice) consistently over time and to trade them infrequently if at all. Minimize frictional costs then capture increases to the per share intrinsic value of the businesses within the index. Getting good results picking individual marketable stocks requires not just a great amount of effort but, in some ways more importantly, the right temperament, an objective assessment of one's own abilities/limits, and the minimization of frictional costs. That sounds easier than it actually is. Of course, it's important to know how to value a business and have the discipline to always buy with a comfortable margin of safety. Yet it's emotions, overconfidence, and excessive frictional costs that often destroys long-term investor returns.
(Buying in the good times when price relative to value is often less attractive, selling in the more challenging times when fear overwhelms the fact that price relative to value is often most attractive. All the while, incurring frictional costs and making unnecessary mistakes resulting from too much trading activity.)
The periodic purchase of an index fund may eliminate the very best possible investment outcomes. Still, since so many participants do underperform, it puts the average investor with a keen awareness of limits (and a controlled temperament such that they don't go crazy at market extremes) at an immediate advantage against many other investors:
"By periodically investing in an index fund...the know-nothing investor can actually out-perform most investment professionals. Paradoxically, when 'dumb' money acknowledges its limitations, it ceases to be dumb." - Warren Buffett in the 1993 Berkshire Hathaway Shareholder Letter
The bottom line is that many participants are kidding themselves that they will outperform buying individual stocks in the long run.
(And a little success early on -- especially if accomplished during a bull market -- will convince some they are good at it before time and experience proves otherwise.)
So many do and likely will continue to have a difficult time beating the market. Again, no argument. It's the attempt to explain that reality with the efficient market hypothesis where the trouble begins. To me, investor underperformance seem mostly unrelated to market efficiency.
The reasons so many underperform?
Some examples but hardly an exhaustive list:
It's cognitive biases of various kinds. It's the wrong kind of temperament. It's overconfidence in abilities; a lack of awareness of limits. It's too much trading and the resulting frictional costs. It's ultra short investment time horizons. It's too much emphasis on macroeconomic analysis, not enough microeconomics. It's too much energy spent attempting to outsmart/outguess near-term market price action.*** It's too much predicting, too little admission what can't be known about an always uncertain future. It's too little focus on and/or not being skilled at judging how market price compares to real per share business value. It's buying something without sufficient margin of safety. It's too little emphasis on long-term effects. It's buying what one doesn't truly understand. It's the view of stocks primarily as something to be flipped for gain -- whether driven by near-term fundamentals or, even worse, something more technical in nature -- instead of as incredibly convenient partial ownership of a business (after all, that's ultimately what a marketable stock is) with the emphasis on what it can produce over time.
It is not necessarily because markets are efficient.
Market participants are certainly free to trade all they want but, for most, that seems rather likely to be not very enriching. Even if many of these things are not easy to entirely fix, the most damaging behaviors, biases, and tendencies can, at least in part, become a bit less damaging. It just requires a serious attempt -- a thoughtful trained response -- by individual market participants as well as those in a position to educate and influence.
(Buffett and Munger certainly try to educate and influence in this way. They have for years even if it seems too many -- though not all, of course -- market participants have decided to mostly ignore their best ideas and, instead, mostly attempt to profit from near-term price action.)
The inevitable reality is that, in aggregate, market participants can only produce the market returns minus frictional costs. That doesn't mean it's not worthwhile to reduce the adverse effects, where possible, of the many behaviors that get market participants into trouble or otherwise hurt results; that doesn't mean it's not worthwhile to seek improved capabilities among market participants.
I happen to think, for lots of reasons, that even if a generalized improvement in participant behavior and skills were to somehow occur, it would still likely result in most underperforming the market as a whole.
(Keep in mind that I consider the above list to be, best case, a mere starting point. In other words, it's hardly a prescription for improvement. Via this list I'm simply suggesting that many of the things in combination could move us, at least directionally, toward capital markets that might serve us better.)
Now, I realize there's an embedded paradox here. Improved participant capability will not necessarily lead to improved returns. If one or a relatively small proportion of participants were to improve their investment skill, they surely may get improved results. Yet if capabilities were to improve somehow, en masse, for a large proportion of participants, results might not improve at all. In fact, it may even, somewhat oddly, lead to fewer participants outperforming.
The reason is simple enough.
Mispriced marketable stocks would become more difficult to find.
Some might then logically wonder: "Then why should we be terribly concerned about widely improving the investment capabilities of participants if overall results won't necessarily improve?" It's a fair question that I'll take a shot at answering later on in this post.
Of course, this all starts with thinking it's even worth trying. In other words, if something is difficult to do well and deserves treatment as a serious undertaking, it doesn't seem wise to broadly propagate the very flawed idea that essentially concludes there's no point in even trying to think about business value because the price is always right or, at least, very nearly right.
"...academics at prestigious business schools...were preaching a newly-fashioned theory: the stock market was totally efficient, and therefore calculations of business value - and even thought, itself - were of no importance in investment activities." - Warren Buffett in the 1985 Berkshire Hathaway Shareholder Letter
Buffett: Indebted to Academics
Take this a step further. If more participants decide to take this way of thinking seriously -- that market prices are generally always correct due to market efficiency so there's no point in trying to outperform -- it should logically lead to prices being even less likely to be "efficient". Think about that. I mean, doesn't an efficient market require very capable, highly engaged, market participants who attempt to make difficult judgments on price versus value in an always uncertain world?
This seems worth at least some careful consideration.
Now, generating attractive results -- all risks considered -- may not be the easiest thing to do.
Yet it's hardly an impossible thing to learn how to do well.
Proponents of efficient markets seem to more than imply it is very nearly a pointless exercise.
There will surely always be mispriced assets -- including the extreme variety -- but some desirable changes to market participant behavior just might lead to fewer of them. That, in itself, would be a victory. There are, of course, many reasons why assets might become mispriced, but aspects of human nature alone pretty much assures they will. In fact, no matter what wise systemic changes are made in the future, they'll almost certainly still decouple from a reasonable estimate of underlying value from time to time.
In any case, fewer mispricings just might mean that capital gets misallocated a bit less frequently and maybe on a smaller scale.
So what's the point of improving investment skills if it's not necessarily going to lead to better results? Well, the market primarily exists to move capital efficiently to where it is needed. It doesn't exist to enrich the participants. In a world of hyperactive casino-like markets, it's worth reminding oneself of this. If desirable changes to market participant behavior actually ended up making it more difficult for individuals to outperform that seems like a perfectly good outcome to me.
(All of this, of course, is unlikely to occur -- at least not with actual human beings on planet earth -- but it's at least one theoretical implication.)
Returns would then mostly have to come from increases to per share intrinsic value of the underlying businesses.
(Instead of via an attempt to profit from price action which is what dominates the current landscape.)
Maybe, just maybe, then all the unnecessary frictional costs -- some that are visible, some that are less so -- in the current system would become front and center.
Okay, so back in the real world that is also not likely to happen anytime soon. It's simply too lucrative for those involved. That doesn't mean it wouldn't be a very good thing if it did happen.
Much of what the beneficiaries of the current system are paid functions, quite literally, like a "tax" on capital.
The compounded long-term real world effect of this "tax" is not at all small.
It all happens rather quietly, so it seem harmless.
Efficient Markets - Part II
* Later in the same UC Santa Barbara speech Munger added this: "...when you logically derived consequences from this wrong theory, you would get conclusions such as: it can never be correct for any corporation to buy its own stock. Because the price by definition is totally efficient, there could never be any advantage. QED. And they taught this theory to some partner at McKinsey when he was at some school of business that had adopted this crazy line of reasoning from economics, and the partner became a paid consultant for the Washington Post. And Washington Post stock was selling at a fifth of what an orangutan could figure was the plain value per share by just counting up the values and dividing. But he so believed what he'd been taught in graduate school that he told the Washington Post they shouldn't buy their own stock. Well, fortunately, they put Warren Buffett on the Board, and he convinced them to buy back more than half of the outstanding stock, which enriched the remaining shareholders by much more than a billion dollars. So, there was at least one instance of a place that quickly killed a wrong academic theory."
** I say that as someone who thinks much can be learned from economists whether they lean politically one way or another. It's too easy to write off or ignore someone's whole body of work because you happen to disagree with an aspect of their thinking -- even if the disagreement happens to be a major one. Beware of confirmation bias. I realize some may not like such an ethos but it's really not such a bad way to go. On this blog, I generally avoid politics and will continue to do so. Having said that, I will say that no one one person or political party has the definitive answers when it comes to economics. It's inherently incredibly complex and confusing no matter what one's politics happens to be. Charlie Munger said it very well at the most recent Berkshire shareholder meeting:
"Our current problems are very confusing. If you aren't confused, you don't understand them very well."
Of course, some ideas warrant more respect and attention than others. I still think it's a good habit to draw from and understand the broadest possible base of ideas as possible even conflicting ones (in fact, especially the conflicting ones).
*** Now this seems a true fool's errand whether the speculation on price action is one done via what seem to be sophisticated methods or not. To me, it's best to be wary of impressive looking but otherwise unnecessary complexity that is, in reality, rather ineffectual (though I'm not suggesting there aren't very successful speculators...of course there is). In my book, speculation includes even those who use some form of fundamental business analysis but are otherwise mostly focused on price action. Investment versus speculation does not come down to whether fundamental analysis is used or not. Both may do so. Investment has as its emphasis what a productive asset will produce over varying but generally very long time horizons; an emphasis on how price compares to what something is intrinsically worth and how that might change -- within a range -- over time. Speculation does not. A speculator's emphasis is mostly if not completely on market price action. There's naturally nothing wrong with speculation in itself, of course, but it just has less in common with investment than some think (even if there's no clear cut line that separates the two activities and there's occasional overlap). There will always be room for speculation. The question is in what proportion. There also will always be businesses with inherently speculative prospects -- more unpredictable future outcomes -- and the shares will trade accordingly. Even with the very best system design, the nature of equity markets is such that they'll always produce, at least in the shorter term, unpredictable and volatile price action.
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