Financial Advice for my Son (and JPL/CIT Employees)


The Efficiency of the Market

The concept of market efficiency is important. The hypothesis of "strong market efficiency" holds that

"All investments are priced to produce the SAME return for the same (necessary) risk."

This is a logical proposition which would definitely be true in a perfectly logical world. For example, if some investment yielded more return for the same risk, then money would flow into such an investment until prices were bid up enough so that the investment yielded the same as all other investments in the same risk category.

Some people believe that the markets are only "weakly efficient". That is, in some cases and for some periods of time, there are differences between investments that can be taken advantage of in order to produce a higher return for the same amount of risk. Inefficiencies must result in fact if there are time lags for a sufficient amount of money to flow into an undervalued investment, if there are instabilities in the market pricing mechanism, or if bandwagon or mob hysteria effects exist. Most often, however, when someone tried to "beat the market", they end up either losing or assuming much more risk.

No one believes that the market is totally inefficient.

Note that there is no evidence that anyone knows better:

- Stockbrokers are not wealthy. Their advice is not sufficient to generate much wealth for themselves. Instead, they depend on commissions from selling you investments.

- Professors of finance are not wealthy. Even a lifetime of study devoted to investments does not allow them to significantly beat the market.

- Statistics on the return from mutual funds show that the number of funds that are repeatedly in the top half of mutual funds for any given period is equal to the number expected from chance! This is in spite of the fact that the directors of the funds get paid millions of dollars per year to beat the market! Thus one can conclude either that these directors cannot beat the market, or that they extract in salaries and fees an amount exactly equal to their winnings from beating the market. Note that the results are the same for investors in mutual funds in either case, and it implies that mutual funds ratings should be ignored.

- One of the most popular and enduring approaches toward predicting whether the stock market is going up or down is the "contrarian" approach. The method is to summarize the sentiment of most investment advisors (stockbrokers, mutual fund managers, investment newletter writers), and then bet that the market will go in the opposite direction!!! (You know you're in a troubled field when the contrarian approach is not only a popular approach, but it works!)

- Economists admit that their detailed computer models and their insightful predictions have no predictive value!

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