Naked Economics (23 page)

Or maybe you know something that the sellers don’t. Perhaps all the people unloading XYZ Corp. missed the
Wall Street Journal
article about XYZ’s new blockbuster drug for male-pattern baldness. Okay, that might happen. But where are the world’s other sophisticated buyers? This stock is a sure thing at $45, yet for some reason Warren Buffett, the traders at Goldman Sachs, and the top Fidelity portfolio managers are not snapping it up. (If they were, the stock would be bid up to a much higher price, just like the Lincoln Park brownstone.) Do you know something that no one else on Wall Street knows (bearing in mind that trading on any information not available to the public is against the law)?

Or maybe someone on Wall Street is pitching you this stock idea. America’s brokerage houses employ a cadre of analysts who spend their days kicking the tires of corporate America. Is all that information wrong? No—though there are plenty of cases of incompetence and conflict of interest. Analysts provide all kinds of legitimate information, just like your real estate agent. When you are shopping for a home, your agent can tell you about neighborhoods, schools, taxes, crime—the kinds of things that matter. Wall Street analysts do the same things for companies; they report on management, future products, the industry, the competition. But that does nothing to guarantee that you are going to earn an above-average return on the stock.

The problem is that everyone else has access to the same information.
This is the essence of the efficient markets theory. The main premise of the theory is that asset prices already reflect all available information. Thus it is difficult, if not impossible, to choose stocks that will outperform the market with any degree of consistency. Why can’t you buy a brownstone in Lincoln Park for $250,000? Because buyers and sellers recognize that such a home is worth much more. A share of XYZ Corp. is no different. Stock prices settle at a fair price given everything that we know or can reasonably predict; prices will rise or fall in the future only in response to unanticipated events—things that we cannot know in the present.

Picking stocks is a lot like trying to pick the shortest checkout line at the grocery store. Do some lines move faster than others? Absolutely, just as some stocks outperform others. Are there things that you can look for that signal how fast one line will move relative to another? Yes. You don’t want to be behind the guy with two full shopping carts or the old woman clutching a fistful of coupons. So why is it that we seldom end up in the shortest line at the grocery store (and most professional stock pickers don’t beat the market average)? Because everyone else is looking at the same things we are and acting accordingly. They can see the guy with two shopping carts, the cashier in training at register three, the coupon queen lined up at register six. Everybody at the checkout tries to pick the fastest line. Sometimes you will be right; sometimes you will be wrong. Over time they will average out, so that if you go to the grocery store often enough, you’ll probably spend about the same amount of time waiting in line as everyone else.

Indeed, we can take the analogy one step further. Suppose that somewhere near the produce aisle you saw an old woman stuffing wads of coupons in her pockets. When you arrive at the checkout and see her in line, you wisely steer your cart somewhere else. As she gets out her coin purse and begins slowly handing coupons to the cashier, you smugly congratulate yourself. Moments later, however, you realize the guy ahead of you forgot to weigh his avocados. “Price check on avocados at register three!” your cashier barks repeatedly as you watch the coupon lady push her groceries out of the store. Who could have predicted that? No one, just as no one would have predicted that MicroStrategy, a high-flying software company, would restate its income on March 19, 2000, essentially wiping millions of dollars of earnings off its books. The stock fell $140 in one day, a 62 percent plunge. Did the investors and portfolio managers who bought MicroStrategy shares think this was going to happen? Of course not.
It’s the things you can’t predict that matter.
Indeed, the next time you are tempted to invest a large sum of money in a single stock, even that of a large and well-established firm, repeat these magic words: Enron, Enron, Enron. Or Lehman, Lehman, Lehman.

Proponents of the efficient markets theory have advice for investors: Just pick a line and stand in it. If assets are priced efficiently, then a monkey throwing darts at the stock pages should choose a porfolio that will perform as well, on average, as the portfolios picked by the Wall Street stars. (Burton Malkiel has pointed out that since diversification is important, the monkey should actually throw a wet towel at the stock pages.) Indeed, investors now have access to their own monkey with a towel: index funds. Index funds are mutual funds that do not purport to pick winners. Instead, they buy and hold a predetermined basket of stocks, such as the S&P 500, the index that comprises America’s largest five hundred companies. Since the S&P 500 is a broad market average, we would expect half of America’s actively managed mutual funds to perform better, and half to perform worse. But that is before expenses. Fund managers charge fees for all the tire-kicking they do; they also incur costs as they trade aggressively. Index funds, like towel-throwing monkeys, are far cheaper to manage.

But that’s all theory. What do the data show? It turns out that the monkey with a towel can be an investor’s best friend. According to Morningstar, a firm that tracks mutual funds, slightly fewer than half of the U.S. actively managed diversified funds beat the S&P 500 over the past year. A more impressive 66 percent of actively-managed funds beat the S&P 500 over the past five years. But look what happens as the time frame gets longer: Only 45 percent of actively managed funds beat the S&P over a twenty-year stretch, which is the most relevant time frame for people saving for retirement or college.
In other words, 55 percent of the mutual funds that claim to have some special stock-picking ability did worse over two decades than a simple index fund, our modern equivalent of a monkey throwing a towel at the stock pages.

If you had invested $10,000 in the average actively managed equity fund in 1973, when Malkiel’s heretical book
A Random Walk Down Wall Street
first came out, it would be worth $355,091 today (many editions later). If you had invested the same amount of money in an S&P 500 index fund, it would now be worth $364,066.

Data notwithstanding, the efficient markets theory is obviously not the most popular idea on Wall Street. There is an old joke about two economists walking down the street. One of them sees a $100 bill lying in the street and points it out to his friend. “Is that a $100 bill lying in the gutter?” he asks.

“No,” his friend replies. “If it were a $100 bill, someone would have picked it up already.”

So they walk on by.

Neither the housing market nor the stock market has behaved lately in ways consistent with such a sensible and orderly view of human behavior. Some of the brightest minds in finance have been chipping away at the efficient markets theory. Behavioral economists have documented the ways in which individuals make flawed decisions: We are prone to herd-like behavior, we have too much confidence in our own abilities, we place too much weight on past trends when predicting the future, and so on. Given that a market is just a collection of individuals’ decisions, it stands to reason that if individuals get things wrong in systematic ways (like overreacting to good and bad news), then markets can get things wrong, too (like bubbles and busts).

There is even a new field, neuroeconomics, that combines economics, cognitive neuroscience, and psychology to explore the role that biology plays in our decision making. One of the most bizarre and intriguing findings is that people with brain damage may be particularly good investors. Why? Because damage to certain parts of the brain can impair the emotional responses that cause the rest of us to do foolish things. A team of researchers from Carnegie Mellon, Stanford, and the University of Iowa conducted an experiment that compared the investment decisions made by fifteen patients with damage to the areas of the brain that control emotions (but with intact logic and cognitive functions) to the investment decisions made by a control group. The brain-damaged investors finished the game with 13 percent more money than the control group, largely, the authors believe, because they do not experience fear and anxiety. The impaired investors took more risks when there were high potential payoffs and got less emotional when they made losses.
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This book is not prescribing brain injury as an investment strategy. However, behavioral economists do believe that by anticipating the flawed decisions that regular investors are likely to make, we can beat the market (or at least avoid being ravaged by it). Yale economist Robert Shiller first challenged the theory of efficient markets in the early 1980s. He became much more famous for his book
Irrational Exuberance,
which argued in 2000 that the stock market was overvalued. He was right. Five years later he argued that there was a bubble in the housing market. He was right again.

If irrational investors are leaving $100 bills strewn about, shouldn’t we be able to pick them up somehow? Yes, argues Richard Thaler, a University of Chicago economist (and the guy who took away the bowl of cashews from his guests back in Chapter 1). Thaler has even been willing to put his money where his theory is. He and some collaborators created a mutual fund that would take advantage of our human imperfections: the behavioral growth fund. I will even admit that after I interviewed Mr. Thaler for Chicago public radio, I decided to toss aside my strong belief in efficient markets and invest a small sum in his fund. How has it done? Very well. The behavioral growth fund has produced an average return of 4.5 percent a year since its inception, compared to an average annual return of 2.3 percent for the S&P 500.

The efficient markets theory isn’t going anywhere soon. In fact, it’s still a crucial concept for any investor to understand, for two reasons. First, markets may do irrational things, but that doesn’t make it easy to make money off those crazy movements, at least not for long. As investors take advantage of a market anomaly, say by buying up stocks that have been irrationally underpriced, they will fix the very inefficiency that they exploited (by bidding up the price of the underpriced stocks until they aren’t underpriced anymore). Think about the original analogy of trying to find the fastest checkout line at the grocery store. Suppose you do find one line that moves predictably faster than the others—maybe it has a really fast cashier and a nimble bagger. This outcome is observable to other shoppers; they are going to pile into your special line until it’s not particularly fast anymore. The chances of you picking the shortest line week after week are essentially nil. Mutual funds work the same way. If a portfolio manager starts beating the market, others will see his oversized returns and copy the strategy, making it less effective in the process. So even if you believe that there will be an occasional $100 bill lying on the ground, you should also recognize that it won’t be lying there for long.

Second, the most effective critics of the efficient markets theory think the average investor probably can’t beat the market and shouldn’t try. Andrew Lo of MIT and A. Craig MacKinlay of the Wharton School are the authors of a book entitled
A Non-Random Walk Down Wall Street
in which they assert that financial experts with extraordinary resources, such as supercomputers, can beat the market by finding and exploiting pricing anomalies. A
BusinessWeek
review of the book noted, “Surprisingly, perhaps, Lo and MacKinlay actually agree with Malkiel’s advice to the average investor. If you don’t have any special expertise or the time and money to find expert help, they say, go ahead and purchase index funds.”
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Warren Buffett, arguably the best stock picker of all time, says the same thing.
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Even Richard Thaler, the guy beating the market with his behavioral growth fund, told the
Wall Street Journal
that he puts most of his retirement savings in index funds.
¹⁰
Indexing is to investing what regular exercise and a low-fat diet are to losing weight: a very good starting point. The burden of proof should fall on anyone who claims to have a better way.

As I’ve already noted, this chapter is not an investment guide. I’ll leave it to others to explain the pros and cons of college savings plans, municipal bonds, variable annuities, and all the other modern investment options. That said, basic economics can give us a sniff test. It provides us with a basic set of rules to which any decent investment advice must conform:

Save. Invest. Repeat.
Let’s return to the most basic idea in this chapter: Capital is scarce. This is the only reason that any kind of investing yields returns. If you have spare capital, then someone will pay you to use it. But you’ve got to have the spare capital first, and the only way to generate spare capital is to spend less than you earn—i.e., save. The more you save, and the sooner you begin saving it, the more rent you can command from the financial markets. Any good book on personal finance will dazzle you with the virtues of compound interest. Suffice it here to note that Albert Einstein is said to have called it the greatest invention of all time.

The flip side, of course, is that if you are spending more cash than you earn, then you will have to “rent” the difference somewhere. And you will have to pay for that privilege. Paying the rent on capital is no different from paying the rent on anything else: It is an expense that crowds out other things you may want to consume later. The cost of living better in the present is living less well in the future. Conversely, the payoff for living frugally in the present is living better in the future. So for now, set aside questions about whether your 401(k) should be in stocks or bonds. The first step is far more simple: Save early, save often, and pay off the credit cards.