On Investing: Efficient Markets
The greatest trick the devil ever played was convincing us to pay a lot of money for expensive investing expertise.
OK, that’s not really the greatest trick. The truly greatest trick has something to do with makeup and changing our appearance, but I can’t really recall it all right now. Anyway.
The point is this: you do not need any specialized knowledge to be a great investor. You do not need to work hard at investing. You do not need to be brainy at all. In fact, if ever there was a section in this book in which you need to combine the three key attributes of modesty, skepticism, and optimism—to avoid the investing traps of braininess, hard work, and stress—it is this chapter, and the next.
Your attitudes toward investing will absolutely determine your success. Here’s my pledge to you: with little knowledge, and even less work, you can accumulate an investment fortune throughout your lifetime.
I’ll start with skepticism in this chapter and then move on to modesty. In the next chapter, I’ll explain the importance of optimism. Finally, I’ll combine all three with my big two-sentence rule on how to invest at the end of Chapter 14.
Skepticism
My first piece of advice: Start with a significant dash of skepticism.
The Financial Infotainment Industrial Complex would have you believe many myths about successful investing, specifically that it:
As a former Wall Street guy myself, I respect the extraordinary brainpower, hard work, vigilance, and high pay of folks in the industry. Please be skeptical of these myths, however, as they pertain to your own life.
Customers of financial services don’t really need any of that. The less brainpower, time, energy, vigilance, and—most importantly—fees you dedicate to investing, I would argue, the better off you will be. You will not only feel better, but you will end up far wealthier in the long run.
I would like you to believe, to know, to trust in your heart of hearts that skeptical voice about the everyday messages from the Financial Infotainment Industrial Complex.
Almost every investment expert you will meet in your life—especially members of the Financial Infotainment Industrial Complex—has something to sell. They became experts because they are purveyors of a specific financial product. I don’t have an actual product to sell you—besides this book—and that is really the key to why I hope you’ll take these ideas to heart. Whether you do or don’t is really up to you. If you want to spend more money for a worse product, hey, it’s your own dime. I won’t be personally affected either way.
More Bad Than Good
I know far more bad ways to invest than I know good ways. I’ve even personally tried most of the bad ways to invest. For my personal account I’ve invested in CDs, individual stocks, high-cost mutual funds, raw land, personal loans, limited partnerships, and options. As a professional fund manager or trustee managing institutional money, I’ve invested in bonds, private equity, auto loans, venture capital, tax liens, seller-financed mortgages, judgments, annuities, REITs, hedge funds, secondary business notes, and defaulted loans. As a Wall Street bond salesman I sold U.S. Treasuries, emerging market bonds, mortgage bonds, CDOs, CMOs, IOs, POs, CMBS, structured derivative notes, convertible bonds, currency exchanges, options, interest rate swaps, and swaptions.
I mention all this just to say that I’ve bought or sold a wide range of investment products in my life. And yet, for all the complexity and variety that I’ve seen, there’s very little of it that you need to engage with, in order to do well in investing. All you really ever need to know personally is captured in these next two chapters and summarized in the end of the next chapter in two sentences. Simplicity really is better when it comes to investing.
So, stay skeptical.
On the importance of modesty, we need a quick overview of a 20th-century classic book on investing: Burton Malkiel’s A Random Walk Down Wall Street.1
Professor Malkiel’s book is worth reading in full, but a brief summary of the biggest idea will get us far enough along on the path to doing the right thing with our own investing.
Malkiel popularized for the investing public the idea of the “efficient markets hypothesis,” which posits that the price of a publicly traded asset (like for a stock or a bond, for example) at any moment reflects the aggregation of all known information about that asset. How does that work? As bad news about a company becomes known, demand for the stock will decrease, causing a price drop. Good news, by contrast, will increase demand for the stock, and the price rises.
Now, understand that we don’t need any single group of investors or investor opinions or trades to be “right” at any given time. Rather, the market price is an aggregation of everyone’s opinions and everyone’s trading. As new information becomes known, prices change. If you embrace the efficient markets hypothesis—spoiler alert, I do—then only “insider information,” unknown to the rest of investors, could give you an edge when trading stocks over other investors. And for most situations, trading on insider information is illegal, so I can’t recommend you try it.
So, what do we do with this hypothesis?
The logical conclusion that proponents of the efficient markets hypothesis draw is that the point of investing in markets should not be to “beat the market,” by trading based on our own knowledge. Because the market—as an aggregation of correct and constantly updating prices at every moment—is efficient, it’s not really plausible or profitable to try to beat it. Instead, the point should be to join it, and just earn whatever the market returns over time.
Now, an entire genre of financial literature dedicates itself to exploring the limits of the efficient markets hypothesis, with questions like:
That’s fine. In fact, in a meta-sense, being skeptical of the efficient markets hypothesis can even be healthy. If you search hard enough, there are plenty of limits to the hypothesis.
But still. Let me save you the headache. Even if you can find some plausible exceptions to efficient markets, the correct modest approach is to assume the hypothesis is true. Even if you think you can beat the market—and maybe some people can—I’m here to tell you not to try. Maybe some people can because they have access to information that you don’t, or they get it faster than others—I’m including both legal and illegal possibilities here—but you, specifically, are very unlikely to get that information. By the time you get your information, the pros have already reacted. Trust me.
Having worked on Wall Street, the astonishing thing about talking to people who have not worked there is how little people understand the combination of brain power and computing power applied to analyzing, buying, and selling investments—every second of the day. Electronic trading reactions happen in milliseconds after the release of information on any given stock. Public markets are far more efficient than most people realize.
So my second piece of advice on investing—stemming from Malkiel’s work, but backed up by my experience on Wall Street—is to approach it with an attitude of extreme modesty. You very likely cannot beat the market, and you shouldn’t bother to try. In fact, you will make more money—by paying less fees, transaction costs, and taxes—if you give up trying to beat the market.
When I say you should not try to beat the market, I do not mean to imply—at all—that you should avoid the market—the stock market in particular. I do not mean to give you the impression that it’s all a rigged game favoring insiders and pros, and that lay people should avoid it.
Nothing could be further from the truth and my views, as I will try to emphasize in the next chapter, on the importance of optimism when investing. Even though the pros are faster than you and me, we still can generate and extract an enormous amount of value by participating in the stock market. In fact, optimistically speaking, there’s never been a better time than now to be an amateur investor, if you remain skeptical and modest in your outlook and approach.
Having emphasized the role of skepticism and modesty when it comes to investing, a few more important ideas need clarification before moving on, in the next chapter, to the role of optimism.
Diversification, or Not
Most investment advisers strongly advise diversifying your investments. Most extremely wealthy people, on the other hand, have extraordinary wealth as a result of undiversified investments, usually by owning their own business. The famously successful investors who built Berkshire Hathaway, Warren Buffett and Charlie Munger, argue that one key to their success over the decades was concentrated, not diversified, investment choices.
So which should you do? To diversify or not to diversify?
While Munger and Buffett did not diversify, and some professional investors do not diversify, they make investing the primary focus of their life. They can conceivably put all their eggs in a few baskets because they deeply understand those eggs and those baskets. That takes a lot of work. In the case of Munger and Buffett, that takes a lifetime of dedication to investing. You cannot replicate their effort and knowledge. You don’t need to do this.
If you approach investing with an undiversified approach but an amateurish part-time effort, I am afraid you will end up taking too many risks. Because investing can and should be an effortless activity for the majority of people, a highly diversified investing approach should work best for the majority of people.
For me, the answer is clear, and it stems from a promise I made at the beginning of these chapters on investing. Keep it simple. Do not work hard at investing. Do not apply specialized knowledge. Remain modest in your approach.
To make money with your money in the easiest possible way, you probably want to diversify.
Individual Securities vs. Mutual Funds
Starting from scratch, a blank investment canvas, I’d always advise buying mutual funds—a basket of stocks—rather than purchasing individual stocks. The first reason is that the efficient markets hypothesis posits that you probably won’t “beat the market” through your individual stock selection, so probably you’re better off just “owning the market” through a diversified mutual fund. Modestly speaking, you cannot know so much more than the rest of the world does about an individual stock, such that it would justify your purchasing that single stock or bond.
I’m not saying you shouldn’t ever own an individual stock, but rather that doing so can’t be justified by financial theory. If you were given a stock as a gift, or acquired it through inheritance, then by all means keep it and cherish it. If you derive pleasure owning the stock of a company you admire, then that pleasure has a value all its own. No need to sell.
If you seek diversification through a basket of individual stocks—let’s say at least 20 or ideally closer to 30 from a variety of different industries—then your individual basket of stocks is a fine proxy for the market and maybe you don’t need to purchase a mutual fund either. I’m OK with that approach, too.
Where you might go wrong as a buyer of individual stocks, however, is in believing that by owning just four stocks that you picked, for example, that you’ve got a good wealth-building plan in place. It might all work out great. It might even outperform a diversified mutual fund. But it might not. I don’t think the risks you’re taking justify the reward.
Furthermore, with your net worth too closely tied to the fortunes of a small number of companies, you might be tempted to trade too often. You might be tempted to do a tremendous amount of work, researching or thinking about your investments. I know for my part that whenever I’ve owned an individual stock that I end up thinking way too much about it for my own good. The temptations to trade, or do work, or research the stocks outweigh, for me, any plausible financial benefit from owning individual stocks over a mutual fund.
ON DRIPS: DIVIDEND REINVESTMENT PROGRAMS
I don’t recommend purchasing individual stocks, when compared to the choice to invest in broadly diversified all-stock mutual funds. One exception to this recommendation that I made happily in my own life was for my kids, as an educational experiment. I wanted them to understand the idea of individual company ownership through owning a stock, so I purchased a small number of shares in one company for each of them.
I mention this because a cool, simple, low-cost, and automated way to buy an individual stock is directly from the company itself. Many companies set up a program for individual investors to buy stocks, without using a brokerage company, through a dividend reinvestment program (commonly known as a DRIP). As the name implies, any dividends earned automatically get reinvested in additional shares of the company’s stock.
DRIP programs also allow you as an investor to own “fractional shares” of company stock.
What does that mean? It means that if you earned $20 in dividends, but a single stock costs $100, the DRIP program would allow you to purchase 0.2 of the individual stock directly from the company. This is an advantage for the small-time investor—like my children. I’m pretty sure a brokerage company won’t let you ever buy a fractional share like this.
Given this combination of low-cost, small-investor orientation, automation, simplicity, and chance to cut out the middleman, you can sort of see why DRIPs appeal to me.
So if you insist on owning individual stocks, check out DRIPs. With a little digging, the “investor relations” portion of the websites of most major public companies can direct you to the administrator of their DRIP programs.
Active vs. Passive Management
One obvious response to the efficient markets hypothesis is to say that maybe the key to beating the market isn’t picking individual stocks, but rather picking individual investment managers who can beat the market. Much of the Financial Infotainment Industrial Complex dedicates itself to raising up, or beating down, supposedly genius investment managers who can do this for you, at a high cost in fees, of course.
This is a psychological challenge, because we want to believe in the potential for genius. And we want to believe that we ourselves can reliably spot genius when we see it.
You can choose what works best for you. For my part, I bring deep modesty and skepticism to the table when evaluating investment managers who purport to beat the market, for a hefty fee. Many managers manage to do it for multiple years in a row, only to underperform in subsequent years. Maybe you’ll be lucky enough to choose a manager whose outperformance consistently beats the market and justifies her higher fees.
I just think it’s difficult, ahead of time, to know which managers that will be. And that’s why we need to remember that past performance is rarely predictive of future results. Those managers who outperform in one financial environment show a pesky habit of underperforming when conditions change.
If you decide to ever do research into the issue of consistent manager outperformance, I don’t recommend you reference marketing materials offered by money managers, as they have something to sell. Rather, seek out independent research done by academic institutions on the ability to consistently beat the market.
I am confident you will find that manager “edge” is ephemeral, while fees, by contrast, are forever. I am confident you will find—because every academic study I’ve ever seen confirms it—that picking managers who consistently beat the market, enough to justify their fees, is a rare feat. If you can find one, somehow, best of luck to you. I’ll remain modestly and skeptically over here, seeking out passive, low-cost managers of my money.
1For a popular and extremely thorough representation of the “efficient markets hypothesis,” which the author dubs “random walk theory,” as well as just an overall great book that inspired index investing in the 1970s, I highly recommend Burton G. Malkiel, A Random Walk Down Wall Street: The Time-Tested Strategy for Successful Investing (New York: Norton, 2012).