If You Can’t Beat It, Join It

Posted on December 16, 2011 at 11:17 AM PDT by

We frequently write about the uncontested fact that most stock pickers, professional or amateurs, don’t consistently beat the market.

We know that rock-star stock pickers like Peter Lynch in fact used to be able to outperform markets years ago. But global stock markets have changed dramatically over the last fifty years, making it nearly impossible to find mispriced stocks. Markets are now considered “efficient,” meaning that whatever a stock is selling for is probably close to what it is worth. Here are five reasons that have contributed to market efficiency:

The rise of institutional investors. In 1960, only 10 percent of all investors were considered professionals. They were like foxes in the hen house of amateur investors. Professionals could get an edge because there was only one of them to every nine amateurs. TodayL, that ratio is reversed. Out of ten trades, nine come from professionals. These pros are certainly frantically trying to get an edge through trading. Back in 1960, only two million shares traded daily on the New York Stock Exchange. Today, there are over four billion shares traded daily.

Concentration of professionals. While there were few pros in 1960, today they are highly concentrated. In fact, the top 50 fund companies generate 50 percent of all commissions on Wall Street. That means when an analyst at Merrill Lynch gets a great idea, or finds out some important factoid that no one knows, he calls those firms first and then publishes his research report a day later. That information is quickly priced into the stock. Those top 50 firms get the edge because they pay for it.

Derivatives. The ability to buy and sell puts and calls (also known as derivatives) is a new invention of the last 50 years. The value represented by these derivatives now exceeds the entire value of the stock market. While these securities allow some investors to hedge positions, their existence creates undue movements in the market, spooking investors and adding to uncertainty.

Certified Financial Analysts (CFAs). Did you know that an entire field devoted to studying the pricing of stocks has developed over the last 50 years? This certification arms the analyst with highly sophisticated tools for studying stocks and analyzing their value. Today there are over 300,000 CFAs all over the world, armed with the IQ points, tools, and training to figure out how a stock should be priced. Their work gets quickly priced into stocks, quickly bidding up the bargain stocks.

Democratization of information. Two major events have made the same information available to everyone: Regulation FD (Fair Disclosure) and the Internet. Until about 2001, analysts and large fund managers would receive “whispers” from company management. An analyst who received a whisper from a CEO was able to inform his clients, who would trade and profit on this information. That’s why analysts were paid way more ten years ago. Reg FD put strict restrictions on insider trading and as a result, there is now little whispering. At the same time, the Internet, e-mail, and even Bloomberg terminals have made information instant and available to everyone. The minute a material piece of information is out, it is picked up by anyone who wishes to buy or sell based upon this new “datapoint.”

If you own Apple or Google because you use the products and think there’s a “long way to go,” realize that you are taking undue risk. If markets are efficient, it means that you’ve bought the stock for exactly what it is worth. You have no edge. And worse, if you pay for a fund manager to make better picks than the overall market, you are wasting your money. You’ll make more in the long run by owning a fund that owns every single stock in a given market. If you want to own emerging markets like Russia, Brazil, India, and China, buy VWO from Vanguard, and own all 900 relevant companies in these countries. Don’t try picking 20 or 30—own them all! This is called investing in indexes, and for these reasons, we recommend only index exchange-traded funds (ETFs) to our clients.