By Alexander Green In my last four columns, we’ve discussed whether luck or skill – or some combination of the two – is the primary determinant of economic success.
Today, we address this question to the stock market. Is investor success there a matter of luck or skill?
For noninvestors and those with very little experience, the answer is easy. It’s luck.
Novices say this because they view the stock market as a gigantic casino, where stocks gyrate madly up and down for little or no reason at all.
And you know what? In the short term, they’re right.
There is no direct correlation from hour to hour or day to day between a company’s share price performance and its profit growth.
That’s why day trading is an utter waste of time.
As the great value investor Benjamin Graham famously said, in the short-term the market is a voting machine. In the long term, it’s a weighing machine.
And what it weighs is earnings.
I challenge you to go back through history and find even a single company that increased its earnings quarter after quarter, year after year, and the stock didn’t tag along.
It doesn’t happen. Share prices follow earnings.
However, some highly knowledgeable people – including most academics – also insist that investment outperformance is a matter of luck, but for an entirely different reason.
They subscribe to the so-called “efficient market hypothesis.” This is the theory that rational, self-interested investors take every bit of material and public information and immediately incorporate it into share prices.
Since all good news and bad news is instantly priced into stocks, it simply isn’t possible to outsmart the market over the long term. Anyone who does is “just lucky.”
Many of these analysts – including well-known investor advocates like Jack Bogle and Burton Malkiel – insist that you should invest exclusively in index funds.
I disagree with these folks. But not completely.
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In my view, the foundation of every investor’s portfolio should consist of index funds. (Hence our market-beating Gone Fishin’ Portfolio.) Index funds offer you broad diversification, low costs and high tax efficiency.
But that doesn’t mean you can’t beat the market by selecting individual stocks.
There is a big difference between saying the stock market is efficient and claiming that it is completely efficient all the time.
Were technology stocks perfectly priced in the late ‘90s during the great internet bubble? Were stocks rationally priced at the market bottom eight years ago, when most had big yields and single-digit P/E ratios?
Of course not. People are not completely rational 100% of the time, and neither are stock prices.
Information is not perfectly disseminated. (This is especially true with small cap stocks and foreign markets, two areas that offer individual stock pickers fine opportunities.) New technologies and drug candidates are often not well understood. And emotions – like fear, greed and hope – often interfere with rational equity pricing.
Warren Buffett once joked that he ought to endow a chair at a major university to teach the efficient market theory. Why? Because if everyone else quit trying to identify undervalued stocks, it would make …read more
Source:: Investment You
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