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The efficient financial market

By David Luhman on Sat, 05/09/2009 - 23:54

The efficient financial market

If you talk to an active investor, she will tell you that she thinks that she can beat the market averages. But note that by definition, it is impossible for everyone to beat the market average because, in aggregate, everyone is the average.

But each investor thinks he or she knows something that the rest of the market doesn't. This is very doubtful.

Unless you're talking about illegal insider trading, there are probably a thousand other investment professionals who know your supposed secret, and already have reacted to the information by pushing the security's price up or down.

There are over 100,000 full-time investment professionals in the United States. If you assume that each of them follows an average of 30 stocks, that means that each of the 3,000 largest stocks are followed by at least 1,000 investment professionals, and this doesn't even count the millions of serious amateur investors out there.

With a thousand professionals constantly monitoring a stock, it will be very difficult for you to beat these full-time pros.

The cost of trying to beat the market

Here's another thing to consider. Hunting for so-called bargains takes time and money.

If you want to beat the market you'll have to pay expensive analysts to read the fine print in quarterly reports, and these same analysts will have to pay news services for reports and buy computers and costly software to perform analysis. Also, trading costs money in commissions and something called slippage which occurs when your buying or selling moves the price against you.

Finally, active trading means that you'll have to pay a lot in capital gains taxes as opposed to the buy-and-hold investor who delays this tax as long as he holds on to his securities.

Can an active trader find enough bargains to overcome the added costs of research and taxes? Academics who developed something called the efficient market theory say no.

This is the end of side 1

This is the end of side 1. To listen to side 2 please fast-forward the tape and turn the cassette over.

The efficient market is one theory that may be right

Although I have three college degrees, I don't put too much stock in a lot of academic thinking. But when it comes to the efficient market theory, I think the ivory tower crowd has stumbled onto something because it's backed up by solid evidence.

The efficient market theory says that since so many intelligent people are hunting for good securities, current market prices already reflect valid prices for those securities.

Now I'm the first to say that some of these smart investment pros often make mistakes, but they also sometimes do very well. But in aggregate, especially over time, they really do no better than market averages.

Index funds beat 75 percent of managed funds

So that's the concept behind the efficient market theory, but what about some evidence that indicates that active trading really won't help you?

A number of independent studies have shown that a so-called index fund, which passively buys and holds an entire basket of stocks like the Standard & Poors 500 stock index, has outperformed 75 percent of all actively managed stock mutual funds. Further, after you figure in the taxes paid by active funds, an index fund beats about 90 percent of the active funds.

Index funds are able to beat actively managed funds because the market already prices most stocks accurately, and because index funds have much lower expenses than active stock funds.

The average stock fund charges annual expenses of 1.4 percent. Much of this money goes into paying for expensive research or a high salary to the supposed hot stock picker.

The typical index fund, however, has annual expenses of only two-tenths of one percent. Over time, stocks have returned about 10 percent per year, so the more than 1 percent advantage enjoyed by an index fund is very hard to beat. And when you add in the tax benefits of a buy-and-hold strategy, the index fund's lead is almost insurmountable.

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