Market Efficiency

YOU COME ACROSS a company with a great product that’s growing like a weed, you buy the stock—and the shares go nowhere. The Commerce Department announces robust economic growth for the latest quarter—and stocks tumble. The Federal Reserve lifts short-term interest rates—and the markets greet the policy change with a collective yawn.

What’s going on here? Stock and bond prices reflect both currently available information and also investors’ collective expectations about future developments. When that new information becomes available, investors quickly buy and sell securities based on whether the news was better or worse than expected. Suppose a company reports a 25% increase in earnings. Impressive? If analysts were forecasting 30% growth, the stock could get pummeled.

This puts ordinary investors in a tough spot. No matter how much research you do, you’re highly unlikely to know something that other investors don’t know (unless you are trading on inside information, which is not advised). True, you could prove better at interpreting this information by, say, predicting correctly that a company’s new product will be more successful than other investors imagine. But how likely is this, especially when you’re competing against professional investors with business degrees, great analytical tools and access to the latest market research?

Alternatively, you could hire some of these professionals to pick investments for you, which is what you do when you purchase actively managed mutual funds. But history tells us most active funds lag behind the market. Even if they post a few years of good results, that winning performance often fizzles out. It isn’t that these money managers are dummies. Rather, the problem is that they and other professional investors are super-smart. If there are investment bargains to be had, they don’t stay that way for long, so it’s hard for managers to beat the market year after year.

This doesn’t mean the markets are perfectly efficient. But they are efficient enough that, once you figure in investment costs, it’s unlikely you will earn market-beating returns, whether you invest on your own or hire a professional money manager. Indeed, after costs, investors collectively must earn less than the market’s return. That’s an unalterable mathematical fact. To make matters worse, the number of winners turns out to be surprisingly small, thanks to a notion known as skewness. The upshot: More and more investors are opting to index.

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