Enrich Your Future 32: Trying to Beat the Market Is a Fool’s Errand

Andrew Stotz 00:02
Andrew, fellow risk takers, this is your worst podcast host, Andrew Stotz from a Stotz Academy, continuing my discussion with Larry Swedroe, who for three decades was the head of Research at Buckingham wealth partners. You can learn more about his story in episode 645, now Larry stands out because he bridges both the academic research world and practical investing. Today we're diving into a chapter from his recent book, enrich your future, the keys to successful investing. And specifically we're going to be talking about chapter 32 the $20 bill Larry, take it away.

Larry Swedroe 00:33
Yeah. So there's an old story, Andrew. It's one of my personal favorites. It's a story about a passionate believer in the efficient markets hypothesis, which says it's extremely difficult to outperform the market by picking stocks or time in the market, because the market already incorporates all information, and you can't be smarter than the market, or it's extremely unlikely. And the story goes like this, that there he's walking down the street talking with a friend, and the friend says, look, there's a $20 bill there. And the economist says, can't be if there was a $20 bill, or someone would have already come by and picked it up. Of course, the person picks up the bill and, well, the people who tell that story may use it as a joke about clearly, the market is inefficient. Well, the right way to tell that story, my version of it anyway, is that there's a passionate defender of the efficient markets hypothesis walking down the street with a friend who spots the $20 bill and there, and the economist says, you better pick that up real fast, because it's going to be gone. You know, very quickly. $20 bills just don't sit around laying on the floor. The other guy, he does pick up the bill and decides he's going to spend his life trying to find these easy $20 bills. Well, a few years go by, and there's the financial economist. He's walking down the street, and he looks over, you know, he's down in New York City, and he looks in some doorway in an alley, and he sees his friend in ragged clothes drinking out of some brown paper bag, some bottle. Doesn't know exactly what it is, but the essence what happened to you says, Well, I went around trying to find $20 bills. I never found another one. And that's really a better example of the markets aren't perfectly efficient. There are occasionally $20 bills that someone can find, but if you can identify an easy way to find those $20 bills, well, the market will learn about it quickly and make those $20 disappear, as if, like somebody found bunch of gold rings on a beach. Well, all the people with metal detectors would be the next day, and within a day or two, there would be no more rings. That's how the efficient market works. There's always some anomalies. Somebody can discover some way to beat the market, but it gets reverse engineered very quickly, and that anomaly disappears.

Andrew Stotz 03:20
I was thinking to myself, does when we say that the market is efficiency, does that mean that there are no inefficiencies? Does are we technically saying, if it's efficient, there are zero inefficiencies?

Larry Swedroe 03:34
Well, there are several versions people have developed, and the efficient markets hypothesis one is the hardcore version, which would say there are no inefficiencies, which we know is wrong. There are plenty of behavioral anomalies. For example, the research shows that small cap growth stocks with high investment and low profitability have had returns below those of T bills, and yet people buy them. Why? Because they're hoping to hit the lottery and find the next Google or Microsoft or Nvidia. And there are limits to arbitrage, meaning the cost of trading and the cost of borrowing, because if you want to bet on a stock being overpriced, like these small cap growth stocks with high investment and low profitability tend to be you have to borrow the stock and go short it. You sell it and now you hopefully buy it back later, lower price. Well, the cost of borrowing can be very expensive and secondarily, unlike when you go longer stock, in which case you can only lose 100% of your money if you go short of stock. As people who shorted game stock correctly, knowing that the stock got way overvalued, but they got. You know, in a short squeeze, and the price went from like $10 to 300 or some crazy number, I forgot exactly, and they went bankrupt. Uh, Melvin capital lost like $4 billion betting on it. So the fear and the unlimited losses and the high cost create what are called limits to arbitrage, which prevents sophisticated investors from correcting mispricings. Momentum is another anomaly which clearly, there's no risk story to momentum. It's people buying things based upon recent performance. But let me give you a more common example, long time ago, there was a paper written on the accrual effect. What it said was, companies that have unusually large accruals tend to go on to unperform, underperform. Why they were tending to recognize revenue too early, and sometimes it never showed up. So counting irregularities, if you will, immediately after that paper was published, the anomaly disappeared because smart people read about it in the literature, and they started to buy, you know, go short the stocks, and that drove the prices down. The anomaly went away. Let me give you one other example to be helpful. So there used to be something known as the January effect, where small cap stocks tended to outperform in January. And that was so if you know that's going to happen? What would you do?

Andrew Stotz 06:43
Andrew, you're going to you're going to buy prior to January, yeah, so

Larry Swedroe 06:48
you're going to buy in December? Yeah, I'm a little smarter than you. I know Andrew is going to buy in December, so I'll buy in November. And high frequency traders, you know, like Citadel capital, they're smarter than me, and they'll buy in October, and then the anomaly is already gone, right? It never gets undervalued. And so once something is discovered, especially if a stock is undervalued, because there aren't the risk and the costs of shorting, these anomalies tend to disappear.

Andrew Stotz 07:22
I'm thinking about there's a word that I always find really strange. The definition of it, it just doesn't make sense to me, and that's altruism. And the definition is something like being, you know, a selfless concern for the well being of others. Well, that doesn't make any sense to me, because I know that nobody's going to go out and help other people in in ways that are going to harm them personally in the process of helping, unless, you know, okay, it's a parent saving a child, and parents going to hurt themselves in the process of saving, you know? And then I would say it's not altruism, it's instinct. And so I that word doesn't make a lot of sense to me. And in some ways, I was thinking about efficiency and thinking, you know, the actual act of correcting is what makes the market efficient. And so to expect that the market is perfectly efficient is actually rejecting the whole process by which the market becomes efficient. So therefore there should never be a something that we would expect that the market is perfectly efficient, you know, as opposed to, you know. So to say that the market is slow and at sometimes and fast at sometimes, at bringing in information into prices, does not tell me that the market is not perfectly efficient. You know, I don't know if I'm explaining it well, but, you know,

Larry Swedroe 08:45
let me see if I can be helpful in this. So if you go back to the early 1960s the field of finance didn't exist. You couldn't get a degree in finance. I graduated from college in 72 and I was one of the first people who actually had a degree in finance. Before that, you got some courses in finance in an accounting program or in an economics program, but William sharp and others came up with the capital asset pricing model to give us the first theory about asset pricing. And that theory said that beta, your amount of exposure, relative market risk relative to the market explained returns. Okay, well, it turned out that that model, which, like all models, are wrong, or we'd call them laws, like we have in physics. You know, gravity is not a theory, it's a law, right? So people went to work and they found all these anomalies. The first one discovered, if you will, or uncovered was a small cap effect. And so then we had this. Value effect that you know, Buffett became famous for, and in 92 farm and French summarized whole bunch of research, which they get credit for, but they never claimed that they didn't invent the small cap and vapor. And they just summarize the research and created a three factor model. Now the CAPM model explained about two thirds of the differences between diversified portfolios. So if you had a higher beta, you should have a higher return. So stocks that were more volatile had higher expected returns. Generally, that was the idea. Now you add size and value these anomalies, and now you're up to about 92% of the variance, so there's still room for anomalies, or, in theory, inefficiency. Right along comes Mark Carhart in 98 and he publishes a paper on momentum. And he's that when you added that you're up to, like, you know, mid 90s. Now, okay, so there's still some inefficiencies. Maybe that could be discovered, because there were 5% that was unexplained. Then comes Robert novery marks in 2012 took another, like 14 years for somebody could figure out the next anomaly, and he found that profitability was a factor, and companies that were more profitable tended to outperform, and then later came an investment factor, and we now have this Five factor model, and now you're up to like 98% of return. So let me just finish this. Take your question. So in 1974 you could claim that the markets were inefficient and you could generate alpha just by buying small and value stocks. By in 1993 you could no longer do that, because I could replicate that by just buying an index of small and value stocks. Then after 94 you could claim by adding momentum stocks or excluding negative momentum stocks, you could outperform, and that was an anomaly in the market was inefficient. Well, can't do that anymore, and then profitability and investment. It doesn't mean we can't uncover anomalies further, because we now have all these high speed computers and tremendously talented mathematicians trying to uncover some but there's not a lot more room. But to give an example. Harvey Campbell, Harvey, a well known professor, has written a lot of good work. He just published a paper talking about how factors are done. He thinks in a less efficient way by defining, let's say, value as the top 30% of stocks and cheapness and growth as the bottom 30% and you go long the cheap and short the expensive. Well, he says that ignores how value is impacted by other factors or impacts. So how does value play with a low volatility factor? How does it play with the profitability factor, and he's so he built a model that said you have to look at the pairs and score them, and the ones that have the best pairs gives you much higher returns. So that's saying there's some inefficiency. Well, I'd be willing to bet, within a reasonably short time, if not already, the high frequency traders and the DFAs and Avantis the world will start to incorporate, if they're not already, you know, doing this, just like they incorporated profitability, etc, Fauci and French just had size and value till 2003 and then they incorporated momentum, and in 2013 they incorporated profitability, and now the market is more efficient, meaning it will be harder and harder for active manage their value. It doesn't mean it can't still be some things found, but it means it's extremely hard to add more of our and find these inefficiencies. So

Andrew Stotz 14:25
let me try to explain one thing first, and that is the concept of what, what William Sharpe was doing, and that was basically he was saying, if you invest in the stock market, you're going to get a certain level of return above the risk free rate and return, yeah, and, and that that, let's, I want to think about that as a pizza, and this is a whole pizza that you're going to get from that, right? And then, as people came along, they go, Well, wait a minute, we can divide that pizza into different parts. And. And it's the same total return relative or prospective return relative to the risk free rate. It's just that now we can attribute, you know, to what is this return coming so we're now coming up with slices, and new slices are a little smaller as they come along, but we do now have five, six slices. And now, would that be a good way of describing it? You

Larry Swedroe 15:21
could describe it that way, but what you're missing from that is some slices have a positive premium like value, and some have a negative premium like growth, a lottery, stocks, stocks you know, that are in bankruptcy. People love to buy them, but 1% of all the stocks that are on bankruptcy, even though they're in indices, so indexes will buy them. 1% of them ever pay out anything to invest. Why do people buy they like buying lottery tickets. That's the explanation there. They love something that even though the odds are against them, it still has the chance to hit the grand slam home run in the bottom of the ninth inning. And you know, you get this massive return, right? So those stocks tend to be overvalued, and the sophisticated investors, it's too risky for them to shorten, okay, so they remain overvalued. Okay, that's an inefficient market. And

Andrew Stotz 16:22
the other question I have is, I believe Fauci and French in their five factor model still do not include momentum in that. Am I correct in saying that? So

Larry Swedroe 16:31
their first model had beta market, beta size and value, then the four factor model added momentum. Then along came the Q factor, which said, we don't need momentum. We just need investment and profitability, and we don't even need value farm. And French went back and looked at it and said, Okay, we will add profitability and investment, but we're going to keep value, but kick out momentum. So that left you with a five factor model, and then they said, Okay, by the way, momentum is still an interesting even if it doesn't add more explanatory power, it individually provide some information, and so they're actually you could run things against the six factor model and show a portfolio's exposure to each of those factors. The most commonly used model now is the five factor, which includes investment, profitability, value, size and beta, that's probably the most commonly used model,

Andrew Stotz 17:45
and just to be just so I understand that is what's being said by Fauci and French, is that one of those five is already representing momentum, like it. Yeah, you could

Larry Swedroe 17:55
say it's their technical term in finance would be, it's impact is subsumed by the other five. Okay.

Andrew Stotz 18:04
And one other question is, in about 1970 fama came out with his efficient capital markets paper, where he was reviewing that, and he talked in that, I believe in that paper, but I know around that time we had weak form, semi strong form and strong form. And I wanted to ask you about strong form. For instance, one of the arguments in strong form is that the market is so efficient, which I think we would argue, the market is highly efficient, that insider traders cannot profit over the long term. Let's say No,

Larry Swedroe 18:39
that's wrong. Tell me more. All you have to do is look at the people in Congress, and how do these people who make 150,000 Larry $20 million like Elon Musk has pointed out, it's because they know that they're writing bills they're going to favor some and no one is stopping them and preventing them from buying those stocks. How did Joe Biden amass all of his wealth? Never made much money, and he never was in a business or any and he just made $200,000 a year or whatever. Right? We also know that there are people who trade on insider trading, and those signals have information. So there is some value there. We know that the markets are not perfectly efficient in that way, but that's why there are rules against insider trading. You if you're gonna buy or sell stock, you have to write it as a plan and say you plan to sell, you know, 10,000 shares every month. Or, you know, over the rest of the year, is to get out of your you know, diversify your position. You can't just walk in and sell on insider information. Or, as Martha Stewart found out, you can end up in jail.

Andrew Stotz 19:59
So. The market is not efficient, not

Larry Swedroe 20:01
perfectly efficient.

Andrew Stotz 20:06
And the argument that people would make that it could be strongly, strong form efficient, is that the market, in theory, would be observing the trading patterns that are hitting the market right then in that stock that's caused by this insider trader, that would trigger a signal to someone who's tracking that

Larry Swedroe 20:24
move the market there. Andrew ang, I think, was the one who wrote a paper called The adaptive Markets Hypothesis, and what he hypothesized is that people discover anomalies, like the accrual anomaly. It gets published, and the anomaly goes away, and as people uncover them, we know the markets can't be perfectly efficient, or Citadel and Renaissance technology couldn't be making all the money that they're making scalping pennies and nickels and dimes on each trade, but they're trading hundreds of 1000s of trades every day. And so it's not perfectly efficient. They spend millions of dollars to get their, you know, computer connections faster access to the data by like, a millisecond, right? And so it's not perfectly efficient. But the best way to think about it is look at the mutual funds, all these experts, highly trained people spending 100% of their time basically on trying to outperform all with advanced degrees, PhDs in finance and math. It's a really smart people access to all the databases, and over 98% of them underperform risk adjusted benchmark before taxes, so the odds of your outperforming are incredibly low. So therefore, how can anyone say the markets are highly inefficient or even inefficient, but we know they're also not perfectly efficient, which gives everyone hope, but hope is not a strategy. So

Andrew Stotz 22:05
going back to our last conversation, when I told the story of Dumb and Dumber, when Jim carries, you know, characters said, So you're telling me there's a chance. Okay? For the

Larry Swedroe 22:19
listeners, chance goodbye. Ah, I had a friend just spoke to him today, who yesterday went in and bought, early in the morning, bought some stocks, and then later in the day, he said, Oh my God, what did I do? Is the market went down. And when he woke up this morning, he went, Oh my God, what did I do? The market was down. And then Trump made his announcement about the delay, and now he's way up. So was he smart or lucky?

Andrew Stotz 22:47
I mean, you know, yeah, interesting. Well, anybody randomly is going to outperform? Yeah, I enjoy the conversation, particularly about efficient market hypothesis and all that, because, you know, it's a cornerstone of finance, so it's fun to talk about it and make sure that we understand it clearly.

Larry Swedroe 23:07
One thing, if the markets were perfectly efficient, then no one could discover anything about a mispriced stock. There were no abnormal behaviors or biases, like investors preferring to buy lottery stocks, then there'd be no incentive for investors to do any research, and then the market would become inefficient. So we're team has to be some incentive for finding inefficiencies, otherwise, the only people who would do it would be idiots, because you couldn't beat the market. So it's unlikely it's a balancing act. And

Andrew Stotz 23:45
I have to ask another question, is the rise of, at some point, will the rise of passive investing go back to the situation where it's actually causing anomalies to then? No,

Larry Swedroe 23:57
I don't think so. Uh, MS, I guess, in theory, if you got to, you know, only five people left trading in the world, but who would those five people be the smartest five people in the world? And who are you exploiting? If you're buying which one of the other four is the dummy who sold you a mispriced stock? That's what people don't understand. If the market is gone from in my lifetime, from about the last 50 years. Call it from about 1% passive to 50. Well, who are the people, as we've talked about before, who drop out? Are these the really smart people who are generating alpha, or the people who are losing and said, I give up? It's right. It's like you're at the poker table with a bunch of average people. The smartest poker player is going to likely keep winning, keep winning, and the losers drop out. And at the end of the game, you got Edward G Robinson against Steve McQueen in The Cincinnati Kid. If you haven't seen that movie, it's a must watch. And who you can't there's no one left to exploit this. This there is no sucker at the poker table anymore.

Andrew Stotz 25:08
Bingen Addie kid, that's one of the great

Larry Swedroe 25:10
there's two great poker movies if you haven't seen that's one of them. And the other is big hand for a little lady, which nobody knows about, but is a great movie with a great cast of actors, including Henry Fonda and a bunch of carrot actors you would all recognize, I'm sure, if you're an old movie buff, a big hand for the little lady. Yes, it's a fabulous little movie. I don't want to tell you anymore, okay, so we give away the story. So we got a big hand. Absolutely great poker movie.

Andrew Stotz 25:43
That's awesome. Wait a minute, I thought the best one was the one my dad and I went to see what was it that played the song, the entertainer with Robert,

Larry Swedroe 25:51
yeah, the Oh, it's the sting this thing, right? Yeah. But that's now that was had a little bit of a poker in it. It wasn't a poker movie. Those two movies are all about poker. Yeah,

Andrew Stotz 26:08
exactly. Well, excellent on that point. Larry, I want to thank you again for joining and I'm looking forward to our next chapter, which is chapter 33 an investor's worst enemy. Hmm, who is our worst enemy? For listeners out there who want to keep up with all that Larry's doing, find him on X Twitter at Larry swedro, and also on LinkedIn. This is your worst podcast host, Andrew Stotz, saying, I will see you on the upside. You.