We don’t “play” the stock market. We “work” it.

Efficient markets

We don’t “play” the stock market. We “work” it.

This is the article that glues together all that we’ve preached about how you need to be an investor, not speculate, and ultimately that your road to personal financial wealth is going to be a boring one.

Having also recently read about the various asset classes that are available and where you might ultimately invest your money, you’re probably eager to get your ‘invest’ on, but before you do, we need to explain something very crucial; the theory of ‘efficient markets’.

Two people have won Nobel prizes for their work on trying to explain how things like shares derive their value, so it’s not a simple subject. But what we will do is tell you enough so that you don’t waste your money, or hit your head up against a brick wall trying to achieve the impossible.

A lot of people have big mouths about the stock market.

When you invest money in the stock market, or if you buy unit trusts, your goal is to no doubt earn some kind of return. Over time you want your investment to grow, maybe giving you some kind of yield along the way, but ultimately you want it to grow and compound over time.

You’re probably thinking that you’ll need to find that investment advisor who really knows and understands global markets, Chinese politics, and which way the Rand might go, so that he can advise you exactly where to invest your money. You recall that television ad that talked about why asset manager X is so brilliant and how their investment philosophy will guide you through all the market ups and downs.

Maybe you heard a radio ad where financial services company Y rattles off all of their awards from last year, and how they were the top ranked fund manager for a whole bunch of things that sound very intelligent to you. Maybe they’re the people you should be investing with?

So what’s the theory?

What the theory of efficient markets says is that there is no point in trying to make a killing or to become the next investing guru – or to even try and find one for that matter.
The ‘market’ is, and always will be, one step ahead of you (and them). Rather, resign yourself from day one, to accepting an investing strategy that sees you investing broadly and not trying to pick winners and avoid the losers.

Put otherwise, with efficient markets, prices are not predictable but rather they are random, so no investment pattern can be figured out. A planned approach to investing in specific asset classes for the purposes of generating superior returns therefore cannot be successful.

Think of it like this

The price of share and therefore a unit trust is at any time really just what the last person paid for it. An agreed upon price between a willing buyer and a willing seller. What the seller agrees to accept for their shares, will ultimately be based on how profitable the company is, the global market for the service that that specific company provides, the state of the global economy…….we could list hundreds of things that might affect the price of the share.

The theory of efficient markets simply says that all this information that is ultimately used to price the share and determine its worth, is based on information that is available to the general population at large. Given that everyone knows this information, everyone should know what it’s worth and nobody is going to pay more than what they know it’s worth.

If it was obvious that shares in Pick ‘n Pay were going to be worth more next week, then the price should already have risen in anticipation of this expectation. Predictable changes in price have already happened and have already been factored into the price today. What is not factored in is the unpredictable stuff.

So for asset managers who have provided returns in excess of the market in general, their performance is really just due to luck. Given that there are so many hundreds of thousands of investors at any one time, there has to be some who do exceptionally well and others who do remarkably poorly.

The exceptions that prove the rule

Theories are nice, as they attempt to bring a sense of order to the world and help explain things we feel need an explanation, but the reality is that they are not infallible. Sometimes prices for assets are higher than they should be, and sometimes there is value to be found.

Value investing, something we’ll touch on in later articles, has been shown in some studies to refute the theory of efficient markets and in the long run, to in fact offer investors superior returns to that of the market in general; so much so that some asset managers have built their entire business model around value investing.

Things are worth what people think they’re worth, and what they might be worth in the future.

We think it fair to say that markets are neither totally efficient nor inefficient. To reconcile all the arguments for and against, we take an approach as follows:

In the short term, markets trade on sentiment, the longer the term, the closer it approaches the fundamentals governing the price of that asset. That’s a complicated sentence, so let’s unpack it:

For example, if a rumour does the rounds that a global rating agency is going to downgrade South Africa’s credit rating, the rand might start to trade lower with respect to the US dollar. The feeling is that once the lower rating comes in, the Rand will devalue. The market starts to price in the expectation of what might happen – now.

When the news comes out that the rating agency did not revise its rating, the rand reverses the losses. Nothing fundamental changes with regard to the rand over this period, just people’s sentiment regarding what might happen.

This sentiment creates volatility and will cause prices to go up and down, when all the fundamentals stay the same, but over the long term, asset prices will be worth what their fair value is.

So what does this mean for me when I need to choose an asset manager or financial advisor?

What the theory of efficient markets says is that asset managers who boast about their prior track record are really only advertising their luck and that asset managers who advertise their proprietary investment strategy to generate superior returns over that which the market would give you, cannot do so over the long term.

Choosing one of these asset managers isn’t necessarily a bad thing if it turns out their promised returns fell short, but where the problem arises is if you paid a fee in anticipation for this superior return. We won’t get into this now, as we’ll discuss ‘compounded costs adding no value’ in great depth in a later article. For now, know that buying something just because it did well last year, or investing your money with someone just because they won performance awards last year, is not wise.

What the theory of efficient markets should also teach you, is that buying a share or unit trust, thinking that the price that it currently trades at, is far less than it’s worth, is short-sighted. If the price of a share in Pick ‘n Pay was really worth a lot more than it was currently trading because of some information you stumble across, or some news report you read about how Pick ‘n Pay is expanding operations into Africa, we can guarantee you that many, many more people who are far cleverer than you, already know this, and that all this information has already been priced into the current share price.

If it’s trading at R20 today, it’s because the market and everyone who buys and sells on the market thinks it’ll be worth that next month, and the month after that.

What we’re not saying

What we’re not saying is that all asset managers are equal and that everyone is bound to earn the same returns over the long run. Rather, this is a cautionary about people selling you on their expertise which in reality, has zero-bearing on their ability to deliver a superior return over the long run.

You’re probably scratching your head right now, thinking that everyone is out to bamboozle you. Don’t fret. Stay with us a little longer, get some more key articles under your belt, and you’ll soon know exactly how to start investing.

The Editors

People who Rock

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