Episode #38 - Are you smarter than the Market?
Could you beat a fifth-grader at picking stocks and timing the stock market?
Intro:
If you grew up in the 90’s you might recall the 1996 family comedy Dunston Checks In. Dunston, a “larcenous orangutan,” does all of the funny things a chimpanzee could do to people on the silver screen. It’s a funny movie, at least from my memory, and it serves as a great springboard to discuss chapter three of The Four Pillars of Investing. Bernstein lays out the inherent weakness in money-managers and the way that they still manage to make money even if they don’t beat the market. Find out how this makes sense in this note!
Chapter Overview:
A trope you’ve likely heard if you’ve ever talked with someone about investing is this: “if you pick stocks randomly you’ll basically do as well, if not better, than any money manager.” Bernstein illustrates this with a parable of the city of Randomvia. The chimpanzees of Randomvia run rampant in the town unless they get to play stock-pickers and no one is allowed to interfere with their picking. How do they choose the stocks, you wonder, a simple formula: dart throwing at a page of stocks from the Wall Street Journal.
You’ll hopefully pardon the absurdity of the image, and you can probably see why I thought of Dunston. What happens to the money that belongs to the humans of Randomvia? Three things:
Over a period of time, some of the chimps do amazing in the market. Humans make money.
Previous “best in class” stock pickers from the chimp community can have terrible performances as often as they do amazing. No prior year’s success indicates the next year’s best picker.
On balance, the average performance of the chimpanzees is the same as the market because they are the only ones with the ability to make trades.
Here’s the catch: The people of Randomvia need to hand over 2% of the income from the stock-picking as fees to the chimpanzees. This lowers the 50% of chimps who beat the market down to 40%. Over a 20 year period, your odds of a market-beating chimpanzee advisor goes down to 10% - this gives you a 1/10 chance of picking the right chimp advisor.
At this point you’ve got the picture: the outcome after reviewing decades of financial data has yielded the result that the hopes for a scientific approach to beat the market is impossible. Year after year success is nowhere near guaranteed. Its effectively the opposite of death and taxes.
Bernstein introduces us to Alfred Cowles III, an avid finance advice newsletter subscriber and I presume his head would not be able to handle Substack (but he’d be into Winnings). In an effort to understand stock recommendations, he wrote an article entitled: “Can Stock Market Forecasters Forecast?” With an abstract that contained three words: “It is doubtful (p. 77).” Frankly, for this chapter alone you’d get your money’s worth from this book.
What about the whales?
Ok, so now you’re likely thinking, “There are totally super successful investors who manager a lot of money and make other people super wealthy. Why can’t I benefit from their wisdom too?”
Two notes:
Once a fund manager is super successful and people flock to invest with them something called “asset bloat” emerges. What is that? In short, when you find a growth stock and want to invest $1,000 you power up Robinhood or Public (or call your broker) and you buy the stock. No one notices. When a successful fund manager wants to invest $25 million into a stock a few problems emerge: a) there is not enough stock for her to buy all of that at once and b) the price will go up when she wants to complete her purchase. The reverse happens when you want to sell - the price goes down by dint of you wanting to sell. You, successful fund manager, control the prices of the stock. (p. 83-84)
What is the “trick” that big money folks utilize to invest for their retirement? Take California Public Employees Retirement System for example. They manage $440 billion (as of January 2021) from the pensions with government jobs in the state of California. Their money is in 60% stocks and 40% bonds. They have access to plenty of money to get the smartest minds on this armada-load of cash and still the best option is just 60% in the S&P and 40% in a Lehman Bond Index. Why people with less money think they should act differently than those with more continues to baffle me.
But Why?
My favorite part of this chapter is the why. Why is it so had to beat dart-throwing monkeys? It’s based on a discovery by economist Eugene Fama:
Because all publicly available information, and most privately available information, is already factored into their prices. (p. 89)
The stock prices adjust because as new information emerges the stock is bought/sold building in the research into the price.
Takeaway:
In my mind, the takeaway from this chapter comes from the lamentation about the mutual fund, specifically an actively managed mutual fund. The problems with these funds is that they take four different types of expenses (see page 94 in the book for the chart) and that makes it even hard for you to benefit from whatever success the mutual fund will have in its performance relative to the market.
Poetically, and James Bond-eque, Bernstein shares: “Performance comes and goes, but expenses are forever.”
Interact:
What are you still sitting with that makes you want to stick with the assumption that “market professionals” are able to beat the market? I’d love to hear your reason and remaining questions!
What did you think of this note?
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Please remember, I’m not providing professional advice about personal finance. I’ve got a lot of friends who do that and you can totally hit me up for an intro if you’d like - I don’t get any commission - just the happiness that my readers are taking their financial health seriously.