The Amateur Financier

It’s an assumption common to just about every human on the planet: in order for one person to benefit, someone else has to lose.  For example, if you’re playing poker with your buddies on Friday night, any profit you make off of the game will be exactly equal to the total losses of your friends.  When you have a hot streak and turn your twenty dollar stake into a fifty dollar pot, it means your buddies must have lost thirty dollars collectively.  Similarly, if you have a horrible night and lose all your money, then one or more of your buddies will walk out the door twenty dollars richer.   As a group, you and your friends will still have the same amount of money with which you came into the game; the only difference will be how that money is distributed.

Such a situation is known as a zero-sum game; the amount of money (or other object of value) is limited to the amount available at the start of the game, and the only effect that the game will have is to shuffle around the money to the various players involved.  (Of course, it doesn’t have to be a literal game; the term is applied to any situation where the only money involved comes from other participants.)  In addition to our poker game example, you can also find zero-sum games in any form of gambling (the money that is won comes from other gamblers, less the casino’s profit margin).  In most sports, any win by one team means a lose by the other; the number of wins is fixed each season, and only so many wins will be distributed.  Even sharing a dessert is a zero-sum situation: if you take a bigger piece of pie, there’s less left for me.

With examples of zero-sum situations abundant in the rest of life, it’s not surprising that many people assume that our entire economy is a zero-sum game.  There’s the underlying belief that there is only a fixed amount of money, and every dollar I get is one less dollar available to you.  You can hear this assumption embedded in our language, with talk about one group or another (usually the already well off) getting ‘a bigger piece of the pie’, as if the economy was served warm and flaky, with a whipped cream topping.  According to this belief, any benefit to another person or group hurts you, cutting down the money supply and decreasing the amount of pie left for you.

Luckily, this is not the case.  It’s possible to create situations that do benefit all the parties involved, something that’s not possible in a zero-sum situation.  (Unless you’re playing with someone who WANTS to lose money, but that rarely happens if all your friends are rational.)  Let’s go back to our pie example.  If you have a piece of pumpkin, which I love but you loathe, and I have a piece of coconut creme, which you enjoy but I detest with the fiery fury of ten thousand suns, we’ll both be better off by trading than we would by keeping what we have.  Similar trades can occur with money; if you put a value of $5 on my piece of coconut creme pie whereas I put a price of $3 on that same piece, we can both benefit when I sell you the piece of pie for, say, $4.  Every voluntary trade between people will increase the wealth of the participants, if only by the cost of a piece of pie.

Furthermore, the economy is not a fixed system; it’s growing all the time.  The pie is getting bigger with each passing decade, ensuring that, even if the pie is not divided as fairly (and of course, if we are not the richest people on the planet, we’re going to assume the division is unfair) as we would like, the size of piece will continue to get bigger.  As more people contribute to the economy, the amount of everything, from desks to microchips to blogs to, yes, pie, increases, making everyone who shares in the economy wealthier.  Things become cheaper, money is easier to acquire, and the quality of life slowly rises, as it has through most of history.  In a word, growth.

What does all of this mean to you, the individual investor?  In a nutshell, money is a tool, nothing more, nothing less.  There is nothing evil about money; it’s simply a medium of exchange, so you don’t have to carry ingots of gold or a flock of sheep with you whenever you want to acquire some other goods.  Money is only as evil as the purpose to which it is put; pay people to kick orphans and stomp on puppies, and you’ll be a pretty bad person, but it’s no more the fault of the money than would be the philanthropy of another wealthy person.  Mostly relevant to our topic, if you have more money, it doesn’t necessarily follow that everyone else has to suffer with less.  In fact, assuming you use your money well, everyone who trades with you can become wealthier in the process, including you.

If you follow the dictates of your conscious and religion as best you can no matter your level of wealth, you will be a good person, regardless of whether your net worth is one million dollars or one thousand dollars.  Do that, and remember that just because you have money, doesn’t mean you took it away from someone else.  (Unless you’re a thief or Bernie Madoff; in those cases, I can’t help you.)

If you are a mutual fund investor, you’ve probably heard talk of the Efficient Markets Hypothesis (EMH, not to be confused with EMT or Emergency Medical Technician) being bandied about at one point or another.  In a nutshell, EMH maintains that the stock market and similar markets are efficient.  That is to say, the price of a stock at any given time will express ALL the information available about the stock at the time, and will usually match the fair value of the company.

Obviously, not every stock will exactly match the fair value of the underlying company at every moment; if they did, there would be little change in stock prices on a daily basis, rather than the swings that we see.  EMH holds that these variations are random and unpredictable, and will revert to fair value as a result of investors attempting to exploit the deviations from fair value.  In a liquid, large market with low costs and people looking to gain advantage from these (temporary) variances, the stock price will soon revert to fair value, at least until the next inefficiency arises.  While it’s possible for some investors to benefit from these inefficiencies, doing so depends on luck and not skill, according to EMH.

As with any such hypothesis, of course, there are challenges to EMH.  The most obvious examples are investors such as Warren Buffett who proved able to beat the market repeatedly.  There are also runs on the market, both on the upside (such as the tech boom) and the downside (as during 2008) where investors end up distorting the market in ways that pull prices away from their fair values in a concerted way.  That the stock market is efficient is far from a settled fact.

Efficient Markets and the Individual Investor

All this might seem like just an academic argument, but it has some very real consequences for your portfolio.  If the EMH theory is correct, your best (and in fact, only sensible) investment is in index funds; barring some lucky (and unpredictable) breaks, neither you nor a mutual fund manager can hope to beat the market, and the best you can do is match the market gains while spending as little money as possible.  If EMH does NOT hold, then beating the market via skill could be possible, and finding good stock investments or a solid mutual fund manager looks more reasonable.

So, which is it; do EMH principles apply or not?  I hold that the answer depends on what segment of the stock market we are considering.  Remember, there are several points that need to be true for markets to be efficient:

-Liquid: It should be possible for shares to be bought and solid easily, enabling the price to easily move back to the fair value for the stock.
-Large: A large market both increases liquidity and helps to ensure that information is widely disseminated, enabling changes from fair value to be easily discerned.
-Low Costs: Low costs increase the liquidity of the market, as well as decreasing the shift in value needed for the investment to be profitable.
-People Looking to Profit from Variances: Without people buying undervalued stocks and selling (or shorting) overvalued ones, the stock prices will stagnate, preventing the stocks from returning to fair value.

The closer a particular segment of the stock market is to meeting these criteria, the more efficient it will be.  For large cap stocks, the market is pretty dang efficient; the market for the AT&Ts and Wal-Marts of the world is large, liquid, and filled with people who will pounce on undervalued or overvalued stocks, pushing them towards their fair value.  On the other end of the spectrum, penny stocks tend to be illiquid, have a small market, and typically have added fees that increase the investment costs; all of which point to a really inefficient market that could potentially be exploited by a savvy investor.  (Although, I’d tend not to recommend penny stocks, as the lack of regulation and easy manipulation by unscrupulous charlatans makes the penny stock market highly risky.)  Most other markets fall somewhere in between; small-cap stocks are going to be less efficient than large-caps, but more efficient (and I would add, safer) than penny stocks.

What does this mean for your portfolio?  If you seek market inefficiencies, look for shares that are rather illiquid (think small cap); it’ll be longer before the market as a whole attempts to change the incorrect valuation, allowing the them to get further from the fair value (and potentially increasing your profit, with a well-chosen stock).  When investing in larger-cap stocks, don’t expect market adjusted to drastically and permanently shift your investment value, all public news will be priced into the stock already.

If you’re more of a mutual fund investor, you’ll likely have an easier time finding mutual funds that beat their respect indexes if you look at smaller cap funds.  A fund manager limited to picking from the S&P 500 for the companies in which the fund invests will have to deal with a liquid market keeping the valuations from getting too far out of touch with the fair market value. Larger cap investments should be considered more for the expected growth and possibly dividends.

The Efficient Markets Hypothesis provides some insight into the method behind creating index funds in the first place.  Whether you believe it’s a fact of investing life, think it’s a load of crock, or somewhere in between will impact just how much of your money you want to put into actively managed investments.  Regardless, the more you learn, the better an investor you’ll become, so enjoy the new knowledge!

(Image Taken from The Daily Gazette at Swarthmore)