Believe this, and you’ll sleep better at night

by Dana on February 24, 2009

Market Inefficient Sleep Better at Night

Modern finance has three perspectives on the workings of the stock market. Inefficient, semi-efficient, and perfectly efficient. For the most part, market observers nowadays believe in a semi to perfectly efficient market. That is to say, information regarding a company is priced into its stock almost instantaneously.

Financial statisticians devote years churning out data to prove that the market, for the most part, is extremely efficient in factoring in new information. And stock prices: barring insider information and uncouth accounting manipulation, is an accurate barometer of the intrinsic value of the company.

Except this is hardly the case. The assumption of market rationality can only be taken so far. We have all seen what happened to the market during the tech bubble and the now real estate bubble. Waves of market decline we are witnessing now may very well signal irrational pessimism: there are many businesses now trading well below their intrinsic value.

Now we need to separate the true investors from the speculators.

Most market experts are behind the notion that buying low and selling high is the right approach to investing. In other words, a successful investor should consistently buy at the lowest point in the market and sell at the point of irrational exuberance. Considering nobody has a crystal ball and thus very few can consistently “time” the market successfully, the industry of technical trading sneaks its way into the investing world. Jargon like resistance, support, and moving average enter the popular vocabulary.  Many people go for it hook, line, and sinker, then get burned attempting the impossible. The impossible being trying to outsmart everybody by applying the gambling mentality to investing.

And then there’s Warren Buffet and his disciples. First, they separate the notion of using stock prices to measure the value of a business. They distrust the oscillatory swings of the market and the speculative herd that drive it. Buffet views buying stocks or bonds akin to owning a slice of the business. If the business is sound, why worry about fluctuations in price? Secondly, the timing issue is eliminated. Berkshire Hathaway does not seek to enter the market at the lowest price, nor exist at the top. Instead, BH makes a point of exiting the market as soon as the stocks are thought to be overvalued, thus providing its shareholders a fair return on their investment regardless of their chosen time of exit.

What a relief, to take back control instead of beholden to a schizophrenic market.

Which brings us back to you as an individual investor. Sure, it would be hard to own a piece of the business you invest in without Buffet’s capital base. But it does bring the point home that you don’t need, nor want to be an opportunist when it comes to investing. If you do bring the gambling mentality into the investment game, then be prepared to lose it all.

But if you are firm in your belief in the competent management and health of a business, and embrace the fact that the market has always been, and will always be driven by greed and fear. If you concede that the market will rarely place a fair or correct value on the stock, but trust that sooner or later, the market will correct itself, then you can sleep much better at night.

picture source: roseandthorn

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  • Skydaemon

    A lot of people misunderstand market mechanics in an important way.

    In the short run, markets do incorporate and discount risk and new information extremely quickly. However, this has little to do with long run efficiency.

    Markets are very efficient in the very long run. But knowing the way markets achieve this is just as important for policy as knowing that it is. This latter point is what the pundits and statisticians always miss.

    Everytime I see someone mention Buffett as an example related to the functioning of markets, it strikes me as pointing out common flaws in thinking about markets. Markets do not achieve efficiency by following smart people. They achieve efficiency by removing the influence of fools, and reallocating greater money/power to people who were less foolish. It is more like playing a game of “the weakest link” than a contest to pick the best. If you start with 100 people, and you eliminate the 50 dumbest, you end up with better answers.

    Buffett is arguably one of the least interesting participants in the market. It would make more sense to study “how not to be like doofus bob” than it does to study how to be like Buffett.

    The worst thing you can do for efficiency of markets and accuracy of pricing is unnatural capital aggregation. The creation of “funds” (mutual funds, pension funds, etc) is very damaging to the efficiency of markets, and no small part of the crisis we now face. The central idea is, no one should control more capital than they are qualified by the market to control. Entering and earning a lot of money in the market like Warren Buffett, qualifies you to wield as much capital as Buffett. If you later become foolish, the market reserves the right to take it back.

    It is true that funds give individuals a better chance in the market, but it is also true that efficiency is damaged in this way. The more efficiency you lose, the more crisis’ like mortgage securities you will have and the larger they will get before imploding. What is gained for individuals, comes at the cost of misallocation of resources across the market, and the ensuing economic and social damage that results.

    The problem with fund managers wielding tens or hundreds of billions, and subscribing to the same strategies as all their peers, gives them collectively enough capital to overpower markets, sometimes for long periods of time. That does not make them correct however. Further, the market has problems removing them, as they have enough unjustified capital to force their stupidity into the market for a long time and to great extents. Whenever markets break such fools, one outcome can be a severe drop such as this one. The greater the fool, and the more unjustified capital they have, the bigger the overshooting and damage must be inflicted to break them. This is what “overshooting” is. It’s a process where the market dangles a carrot over a ledge and lets the biggest fools self-select for extinction, and it’s necessary for markets to be efficient and stable in the long run. The elimination of overshooting would destroy the efficiency of markets.

    If every individual in the world invested themselves, you would have a hard time finding a lot of people to sell $140 oil to, or subprime mortgages backed with worthless derivatives without a big discount or interest rate. But your mutual and pension funds thought it was a great idea and spoke for millions of people in one shot.

  • Skydaemon

    A lot of people misunderstand market mechanics in an important way.

    In the short run, markets do incorporate and discount risk and new information extremely quickly. However, this has little to do with long run efficiency.

    Markets are very efficient in the very long run. But knowing the way markets achieve this is just as important for policy as knowing that it is. This latter point is what the pundits and statisticians always miss.

    Everytime I see someone mention Buffett as an example related to the functioning of markets, it strikes me as pointing out common flaws in thinking about markets. Markets do not achieve efficiency by following smart people. They achieve efficiency by removing the influence of fools, and reallocating greater money/power to people who were less foolish. It is more like playing a game of “the weakest link” than a contest to pick the best. If you start with 100 people, and you eliminate the 50 dumbest, you end up with better answers.

    Buffett is arguably one of the least interesting participants in the market. It would make more sense to study “how not to be like doofus bob” than it does to study how to be like Buffett.

    The worst thing you can do for efficiency of markets and accuracy of pricing is unnatural capital aggregation. The creation of “funds” (mutual funds, pension funds, etc) is very damaging to the efficiency of markets, and no small part of the crisis we now face. The central idea is, no one should control more capital than they are qualified by the market to control. Entering and earning a lot of money in the market like Warren Buffett, qualifies you to wield as much capital as Buffett. If you later become foolish, the market reserves the right to take it back.

    It is true that funds give individuals a better chance in the market, but it is also true that efficiency is damaged in this way. The more efficiency you lose, the more crisis’ like mortgage securities you will have and the larger they will get before imploding. What is gained for individuals, comes at the cost of misallocation of resources across the market, and the ensuing economic and social damage that results.

    The problem with fund managers wielding tens or hundreds of billions, and subscribing to the same strategies as all their peers, gives them collectively enough capital to overpower markets, sometimes for long periods of time. That does not make them correct however. Further, the market has problems removing them, as they have enough unjustified capital to force their stupidity into the market for a long time and to great extents. Whenever markets break such fools, one outcome can be a severe drop such as this one. The greater the fool, and the more unjustified capital they have, the bigger the overshooting and damage must be inflicted to break them. This is what “overshooting” is. It’s a process where the market dangles a carrot over a ledge and lets the biggest fools self-select for extinction, and it’s necessary for markets to be efficient and stable in the long run. The elimination of overshooting would destroy the efficiency of markets.

    If every individual in the world invested themselves, you would have a hard time finding a lot of people to sell $140 oil to, or subprime mortgages backed with worthless derivatives without a big discount or interest rate. But your mutual and pension funds thought it was a great idea and spoke for millions of people in one shot.

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