Personal Finance

How Expert Are Expert Stock Pickers?

In this first video in our Personal Finance section of Macroeconomics -- and also our new course on Money Skills -- we’ll begin to lay out some smart rules for investing.

Today, we’ll tackle Rule 1—ignore the expert stock pickers.

What’s the basis of that rule? Well, in his 1973 book, A Random Walk Down Wall Street, economist Burton Malkiel made a controversial claim. He claimed that a blindfolded monkey, throwing darts at the financial pages, could select a basket of stocks that would do just as well as a set chosen by the pros.

One of Malkiel's later students, the journalist John Stossel, set out to test that claim. Stossel did throw darts at the financial pages. The darts landed on 30 companies. Turns out, Malkiel did have it right—the randomly-selected stocks did better than professionally-picked ones.

The point here is, random picking roughly gives you as good results, as trusting the pros. Consider—in most years from 1963-2008, the S&P 500 Index outperformed most of the managed mutual funds. And in a different study, researchers took the top 25% best-performing funds. Two years later, less than 4% of the original set remained in the top quarter. Five years later? Only 1% stuck around.

Basically—past performance doesn’t guarantee future results. Chance often tends to win out.

To show you what we mean, take a hypothetical set of 1000 experts making market predictions. Let those predictions be based on a coin toss. Experts who land heads will say the market will surge this year. Those who land tails say the opposite. At the end of the experiment’s first year, 500 of the 1000 experts will have been right, solely by chance. Now, say the remaining 500 toss again. At the end of the second year, 250 experts will have been right, again by chance. Continue with this logic, and by the end of the fifth year, roughly 32 of the 1000 will have been right, five years running.

Perhaps these 32 will be hailed as geniuses, but remember, they only came about through a coin toss.

So, what’s to conclude from this? Two things.

First, luck and chance matter. In some cases, it can be hard to differentiate luck from skill, as proven by the “genius” 32. Second, no need to spend big bucks on a money manager. After all, the studies prove that random picking often works just as well as professional management.

That said, what if you did have market information? What if you knew something about certain stocks, that made you think they'd do well? Could you beat the market then? That’s what we’ll answer in our next video, when we tackle the efficient market hypothesis. Stay tuned!

Can You Beat the Market?

On average, even professional money managers don’t beat the market. To show you why, here’s a scenario to consider:

Say we advise you to invest in companies serving the aging US population. Since the percentage of elderly will rise over the coming decades, it makes sense to invest now in products and services that the elderly might need. Sounds logical, right? Wrong.

See, the aging of the US population isn’t a secret. It’s public information. Now, say you acted on the information and did buy stock as we advised. The current price of that stock already reflects information known to the market. Thus, it’s hard to systematically outperform the market, given that everyone else tends to have the same information you do. This is also the main idea behind the efficient market hypothesis.

According to the efficient market hypothesis, the prices of traded assets already reflect all publicly available information.

With information available to buyers and sellers alike, no one has any sustainable advantage over anyone else. This is why even the pros tend not to beat the market. And that aside, even if news did pop up to change the price of an asset, it would be at random and would likely be reflected in the asset price almost immediately. So there’s no reliable way to forecast performance.

As proof of that, take the Challenger space shuttle crash of January 28, 1986. Within minutes of the crash, the news hit the Dow Jones wire service. The stock prices of the major contractors who helped build the shuttle fell immediately. Keep in mind: that was in the 80s. At today’s pace, new information can change stock prices within seconds. This is why stock tips often end up obsolete.

So to sum up—it’s hard to beat the market. You have to accept that.

Still, how should you invest? That’s what we’ll discuss in the next video.

Investing: Why You Should Diversify

So far, we’ve been telling you what not to do when investing. Here’s what you should do: diversify.

Don’t put all your eggs in one basket. Definitely, don’t put your investment money solely in your employer’s stock. That’s very loyal, but it’s a terrible strategy. Just think of Enron’s employees. They had huge chunks of their retirement funds in company stock. Upon Enron’s collapse, many employees who were once multimillionaires ended up with almost nothing.

As you can see, diversification is much safer. Diversification reduces risk by spreading your investment across different assets, doing so without reducing potential returns. Plus, modern financial markets make diversification easy. For example, our favorite investment instrument is the low-fee index fund. These funds mimic a large market basket of stocks, like the S&P 500. The sheer variety in the fund is what mitigates the risk. It’s diversification for the win.

A quick reminder, though. Choose an index fund with low fees. Fees may seem trivial, until you watch them eat away at your investment. Imagine this: take a hypothetical $10,000. Invest that in a fund with a 1% fee, and you’ll have roughly $57.5K after 25 years, assuming an average 8% return. Now, invest the same $10K, in a fund with a 0.2% fee.You’ll get roughly $70K over the same quarter-century.

Our point is—when it comes to investing, simple is best. So for example, if your employer offers a 401K, take the offer!

That being said, you might believe that the market is irrational. Anomalous, even.

No worries.

Next time, we’ll tackle behavioral finance to see if you can profit from anomalies, and irrationality.

Who Is More Rational? You or the Market?

We mentioned before that it’s hard to beat the market. And you shouldn’t try. But what about market anomalies?

One anomaly is the Momentum Effect—where past stock performance predicts future performance, at least a bit. As an example, portfolios with past winners tend to outperform the market in the medium term. Why is that? The market sometimes under-responds to changes in information. Thus, some stocks can lag, even if rationally, they shouldn’t. This is why picking past winners can generate some profit, though the profit’s usually small.

There are also other anomalies, like the Monday Effect, where stocks fall more on Mondays. Or, there’s the January Effect, which says that stocks surge higher in that month. There’s been some evidence for these effects, but these anomalies don’t last.

Despite its flaws, the market is still more rational than you. Don’t forget, you’re probably like most individual traders. You may become overconfident. You may not calculate probabilities that well. And if the market crashes, you’re likely to act more emotionally than you should—just like everyone else.

But don’t just take our word for it — even Warren Buffett agrees! Don’t try to beat the market.

Econ Duel: Rent or Buy?

Owning a home is a huge part of the American Dream. But is the dream of homeownership really all it’s cracked up to be?

In this new Econ Duel from Marginal Revolution University, Professors Tyler Cowen and Alex Tabarrok weigh in on the issue. Each representing a side of the home ownership debate, the two professors ask what’s smarter—to rent, or to buy?

On the “buy” side, Tyler Cowen shares the tax advantages of buying a home as well as the effect homeownership has on one’s stability and savings regimen. Does buying a home force us into better savings habits?

Against those arguments, we have Alex Tabarrok, coming down on the “rent” side of the equation.

Among other points, he talks about the real beneficiary of tax breaks (hint: It may not be you!). Along with that, Alex tackles the trials and tribulations of home-buying, in places like San Francisco, New York, or Boston, where a combination of scarce building permits and increased demand drive up home prices. Plus, doesn’t owning a home -- and committing a 20% down payment -- break the diversification rule of good investing?

All that said, though, here’s the real question that matters—which side are YOU on? Watch and let us know in the comments!

Personal Finance

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