The best way to invest is NOT by cherry-picking the best stocks, or buying at low and selling at high price, or using derivatives, as many people think.
“The evidence is overwhelming that [people] trying to buy when the stocks are low and sell when they are high [have] a TERRIBLE, AWFUL record.” – Paul Samuelson, The Father of Modern Economics, The 1970 Nobel Prize Winner
"How many of you have seen stock-picking magazines? I do not care it is is Forbes, Fortune, [Bloomberg] Businessweek saying: "here is the hot stock," "here is the hot manager," "here is what is going to win next year." BULL! That's total BULL." - William Sharpe, Professor at Stanford University, The 1990 Nobel Prize Winner
“Only liars manage always to be out of the market during bad times and in during good times.” - Bernard Baruch, legendary Wall Street investor
The Efficient Market Hypothesis (EMH) was developed by the 2013 Nobel Laureate Eugene Fama, also known as the father of mother finance and the fifth most cited economist of all time (2019). According to the EMH theory, stock prices adjust to reflect all information available without delay. Therefore, it is impossible (even for professionals) to constantly “beat the market,” i.e. to have better returns than the market average. In other words, if you try to buy stocks at a low and sell it at a high, you will have financial returns lower than buying a simple market index and doing nothing.
As we already saw in "Mutual and Hedge Funds", even investment funds managed by professionals trying to buy stocks at a low and sell at a high price cannot do so most of the time. According to Professor Malkiel from Princeton University, “2/3 of the active managers are outperformed by the [market] index [like the S&P 500] and the 1/3 [who] outperform in 1 year are not the same as the ones who do it the next year.” Many datasets, including the Lipper and The Vanguard Group data, confirm such numbers (table 1).
From a historical perspective, it is tricky to measure mutual funds in the long run as the worst performers tend go out of business, leaving only the best performers ("survivor" funds) with data to estimate financial returns. This creates an upward bias on mutual funds return averages. On the other hand, once you are investing, it is virtually impossible to know which fund will go out of business in the future. Despite this upward bias, in a 26-year period, professionally managed mutual funds have underperformed the simplest market indexes (S&P 500 and Wilshire 500) as you can see
Source: Siegel (1994)
in table 2, excluding their fees. When accounting for funds fees, the scenario looks even worse for fund investors. On average, in a 30-year period, normal investors (like you and I) lose more than $30 thousand for each $10 invested in standard funds. Studies also indicate that 90% of day trade investors (i.e. people who buy and sell assets every day) suffer financial losses rather than making money. In the short term, markets are random and even a blindfolded monkey throwing darts at the stock pages in a newspaper outperform Wall Street professionals (Malkiel, 1973).
It is true that there are important indications that markets are not perfectly efficient. Eugene Fama himself stated that it has been long established that “the adjustment of announcements to earnings is very quick, but not complete […] Not enough to make any profits on it, but so what? […] That’s an indication that the markets are not completely efficient.” There is also important literature on momentum, that is stock prices that are going up tend to continue to go up and stocks that are going down tend to continue to go down (e.g. Jegadeesh and Titman, 1993). A potential explanation for market anomalies would be that investors are not rational (e.g. Shiller, 2000). All of that is academically correct. However, most people, like me and you, are more interested if you can constantly earn more money than the market and the empirical evidence overwhelmingly suggests that it is not possible. Markets are not perfectly efficient but they are efficient enough so that it is impossible to constantly beat the market.
Thus, it remains quite unanimous among academics that the Efficient Market Hypothesis remains a fundamental idea for investors trying to persistently generate financial gains out of investments. Trying to cherry pick stocks, buying stocks at a "low price" and sell them at a "high price," or even giving your money for professionals to do so is a terrible idea. Even strong critics of the Efficient Market Hypothesis, like the 2017 Nobel Prize Winner, Richard Thaler, agree that amateur investors should behave as if markets were efficient. Given that, the best way to invest is to buy “very broadly diversified very low-cost index funds” (William Sharpe, the 1990 Nobel Prize Winner).
If markets are efficient enough that it is impossible to buy stocks at a low price and sell at a high price, how some people like Warren Buffett can outperform the market for so many years?
The efficient market hypothesis (EMH) does not say that it is impossible to have gains on the market. You can buy a stock that will go up and you will make money. But the stock can go up or down in the short term and you cannot predict it. Therefore, it is a kind of coin flip. If you take millions of investors around the world, statistically speaking, you are always going to have a few individuals who have an extremely improbable streak of luck. Moreover, Warren Buffett, specifically, is a very passive investor. He rarely buys and sells stocks. That decreases the “amount of coin flips” he needs to play.
2. Weak Form Efficient Market Hypothesis
There are three forms of market efficiency according to the efficient market hypothesis: weak, semi-strong, strong forms. Only in the strong form any information available, public or not publicly known (like insider information), is reflected in stock prices. However, no market in the world has a strong form of market efficiency multiples studies show. Thus, many people who constantly outperform the market could potentially have or have had private information, like insider information.
3. You Cannot Find The Next Warren Buffett
No major academic model, including the Efficient Market Hypothesis, is perfect enough to rule out the possibility that 1 person can consistently outperform the market. Moreover, a handful of investors (like Warren Buffett) indeed have outperformed the market by an extremely improbable period and margin. Therefore, if these "special" investors exist, how could you find them? The simple answer is: you basically cannot find them. Check "Finding the best fund" to understand why looking for "special" investors is not a game worth playing.
- Fama, Eugene (1970). "Efficient Capital Markets: A Review of Theory and Empirical Work," Journal of Finance, American Finance Association, vol. 25(2), pages 383-417.
- Jegadeesh, Narasimhan; Titman, Sheridan (1993). "Returns to Buying Winners and Selling Losers: Implications for Stock Market Efficiency". Journal of Finance. 48 (48): 65–91.
- Malkiel, Burton Gordon (1973). A Random Walk down Wall Street: The Time-Tested Strategy for Successful Investing. New York: W.W. Norton.
- Siegel, Jeremy (1994). Stocks for the long run: the definitive guide to financial market returns and long-term investment strategies. New York: McGraw-Hill.
- Shiller, Robert (2000). Irrational Exuberance. Princeton, N.J. :Princeton University Press.
- Eugene Fama and Richard Thaler in “Are markets efficient?” by Chicago Booth Review
- William Sharpe in "The golden rules of investing" by Sensible Investing
- Burton Malkiel in "A Random Walk Down Wall Street" In ‘73. Have His Views Changed? by Wealth Track
- Paul Samuelson in "Where Nobel Economists Put Their Money" by BUToday