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Top Secret: For serious investors only

You aren't smarter than the market

It's true. The market knows everything you know and a great many things that you don't, because it draws on the knowledge of all investors. Furthermore, due to statistical and market forces that are weird, counter-intuitive, and far too complex for me to describe, the most knowledgeable and insightful investors influence the market proportionally more than less knowledgeable and insightful investors.

In 2013, three Americans, including Eugene Fama, were awarded the Nobel Prize in economics. Fama is most well known for the Efficient Market Hypothesis, which posits that in a truly liquid and free market, (and despite some issues, the US markets mostly meet this standard) the market is always assigning the most rational possible value to things. When first introduced to the theory, most people find it almost laughable. How could a market be rational when it assigns a value of, say, $100 to a stock one day, they $90 three days later when nothing has changed, except that the market has been through one of its common mini-panics, and all stock prices have fallen?

In fact, there is nothing in the situation I just described that suggests irrationality is at play. The top level issue here is whether money is going into or coming out of the market, and that can be affected by anything . War, disease, weather, solar flares... or more mundane issues, such as GDP reports, exchange rates, bond yields… it goes on and on. Usually, there are so many factors and sub-factors in play at once that no one can point to a single explanation for why the market might drop 10% over three days. But that merely suggests complexity , not irrationality .

As to why stocks tend to rise or fall together, nothing could be more rational. If money is coming out of the energy sector, and this causes the price of energy stocks to fall, it will cause the dividend yields of those stocks to rise and their P/E Ratios to fall, which will cause value investors to sell in other sectors and move in.

Sadly, the moral of this story is that over time, very few of us will do better trading individual stocks than we will in a broad-based index fund. I suspect I'm not the only one who, reading those words, feels withdrawal pains coming on.

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This article was originally published on MarketIntelligenceCenter.com

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.


The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.