The Stock Market (Part 1)

I no longer invest in individual stocks. This has partially to do with my distaste for the market as a place where people move around scads of money without actually doing anything productive besides making life miserable for the people working inside those companies.

But it also has to do with the conviction that the stock market is a thinly disguised casino without the courage to admit that it is nothing more than a high-stakes crap game. At least Caesar's Palace doesn't pretend that there is some kind of science going on.

Financial journalists love to give big headlines to market analysts who correctly predict certain events, like the woman who hit the front pages for having predicted the last crash. What they don't tell us about is the dozens of her predictions that were dead wrong. This is the same scam that allows charlatans like Jeanne Dixon to stay in business.

There's an analogous scam in the horse racing world, a classic wherein you buy a race tip but don't have to pay if the tip proves wrong. Let's say you want them to pick you a winner in the sixth at Aqueduct. They tell you, for twenty bucks, that Truxton Hanover is a sure thing. If you call again in ten minutes under a different name, they'll tell you Vicious Vixen can't lose, and that'll be twenty bucks, please. Essentially, they pick horses randomly and spread them out so that if 900 people call for tips, 100 of them will be given one horse, 100 of them another horse, and so on. No matter which horse wins – and these guys could care less which one – they will have been right 100 times, which represents $2,000 in income for them, despite all the tips having been totally worthless. The people who won are happy to pay the fee, and the people who lost don't have to pay for their tip, and they don't feel cheated even though they lost the bets they laid down on their picks. It's a perfect fraud.

Trying to zero in on stock brokers who "made money" over a certain time frame doesn't make any sense. For example, let's say you happen to pick the time frame 1991-1997. A broker would have to have been a complete idiot not to have made money during this period: a rising tide, after all, does float all ships, and the market shot up like a Saturn rocket during those years.

A better measure is beating the market.

If you sufficiently diversify your portfolio, your gains or losses will roughly track along with the market in general. But if you pick your sticks individually, and if the market value of your portfolio increases by a greater percentage than the overall market did, you "beat the market." This is how a broker or adviser should be measured.

As you might imagine, the number of financial wizards who come out smelling good by this measure is a small fraction of those who simply "made money."

Of course, there are a number of key indicators that could be manipulated here as well, the most absurd, useless and anachronistic being the Dow Jones industrial average, but there are ways to keep it honest.

In any event, let's assume that every stock's current price reflects everything that is known about it at the present time. This is known as the "efficient market" theory.

For example, let's say you know that that the Defense Department is about to let a bid for a hundred titanium-clad aircraft carriers.

Armed with this information, you decide it a good bet to invest heavily in Acme Titanium. No matter who gets the construction contract, they're going to need scads of titanium and Acme has it.

The problem is, a million other people also know about the contract. And they have been buying up Acme stock. The price of Acme's stock has therefore already risen and that's how a piece of current information is reflected in its price.

No matter how smart you are or how closely you study the fundamentals, others have already done the same thing and their buying patterns have already set the stock's price to somewhere close to the level it would be if all those research items panned out.

("Almost" but not quite. Because a strong indication isn't as good as the real thing. So if you buy the stock and the good projections do pan out, you will make money. And you'll lose if they don't. Over the long haul, all of these will net out – it's the concept of "expected value" – and you will essentially break even.)

If you believe this line of logic – and I do, wholeheartedly – there is only one conclusion you can draw: the only real way to beat the market is using insider information. That is, acting on data that is not generally available and thereby getting a jump on the rest of the world. This, of course, is illegal, because it's unfair.

Or is it?

Assume that Acme is about to get thrown out of the country in which it mines 90 percent of its titanium. If you were to buy their stock a week before this occurred, you'd lose your shirt.

But suppose somebody inside the company knows it's going to happen, and he starts dumping large chunks of stock, which drives the price down. Other "insiders" do the same, until the market price of the stock, once again, reflects what is currently known about it, even if that information isn't widely available.

These insiders just saved your shirt.

Insider trading protects the small investor by ensuring that there are no sudden, catastrophic surprises that could get you wiped out.

Of course, the flip side is that the same insiders will also prevent you from making a killing. But that's the tradeoff for all that protection.

In other words, insiders make sure that a stock's price is always reflective of all the information available so that, bottom line, we basic peasants can't make – or lose – any real money except by pure luck.

So when you buy a stock, its chances of going up by more than the overall market average are 50-50, which are the same as its chances of going down by more than the average.

Now, let's get back to those genius financial analysts...

I don't know how many brokers and other wizards there are on Wall Street, but let's say 10,000 just for the hell of it.

Let's also assume that, even if they're smarter than you are, it doesn't make any difference because all the smarts in the world have already been exploited in setting stock prices.

(All their brains have already been brought to bear on your behalf and are reflected in current stock prices. You think your broker has a better research department than somebody else's? Fine. Do you also think that you're the only investor on the planet to whom they've reported that research? They tell everybody! And everybody has already acted on it and made their purchases accordingly and...you guessed it: it's already shown up in the stock price.)

So they've got the same 50-50 odds as you.

What this means is that, in any given year, 5,000 of those brokers are going to beat the market and look pretty good, even though they did it by pure chance.

What about two years in a row? 2,500 will beat the market.

Three years? 1,250.

Over five years, 312 (a little over three percent) will have perfect records and it will be hard for anyone to believe that they're not absolute geniuses. But simple statistics practically guarantees the outcome, even if all these brokers did was make their picks by throwing darts at the stock sheets. (This was actually done once, in a very famous study. The Dart Portfolio made a ton of dough.)

To be candid, in actual life, it turns out that more than this percentage of brokers will beat the market.

Financial brilliance? A flaw in my thesis?

No.

Those are the guys with insider information.

And let me tell you something: if they have it, they sure as hell aren't going to tell you about it.

Brokers make money by making you trade stocks. They draw you to them by claiming that they are smarter and know more and can therefore make money for you by picking stocks better. And for a certain percentage of their customers, that's going to look like a valid claim.

Just like the guys who pick horses for twenty bucks are going to look good to a certain percentage of their customers. And for the same reason, although better disguised.

If all of these wizards were as smart as they want you to think they are, they'd be trading only their own money and wouldn't need to be in the brokerage business at all. What the hell would they need you for?

Here's a challenge: let brokers publish all their predictions every day for a year, and then let's draw up some report cards. I don't invest in stocks but I'd be willing to bet some mighty heavy bucks on what the outcome of that little experiment would be.

Those who can, do. Those who can't, give stock advice.

 


from: A Practical Guide for Everyday Living, by Lee Gruenfeld
* Copyright 1996, 1997 by Steeplechase Run, Inc. - All Rights Reserved

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