Enrich Your Future 02: How Markets Set Prices

Andrew Stotz 00:00
Hey, fellow risk takers, this is your worst podcast host Andrew Stotz, from a Stotz Academy, and today, I'm continuing my discussions 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. Larry deeply understands the world of academic research about investing and especially risk and today we're going to discuss Chapter Two of his book enrich your future, the keys to successful investing. Chapter Two is how markets set prices. Larry, take it away.

Larry Swedroe 00:39
Yeah, this is something that is probably the most important thing investors need to learn before they invest a penny. Because otherwise, you don't know whether the stock you're buying is undervalued, overvalued, might have opinions. But you should really have a good understanding how did the market get to that specific price. So you can then make maybe some judgment or choose to allow the market in its collective wisdom to make a judgement for you. Okay, so I searched for quite a while to come up with a way to have an analogy that people could relate to. So they can understand this very difficult concept of how markets actually set prices. I'm feel pretty proud that I've came up with this idea that almost everyone understands. And if you walk them through it enough, then they will understand how markets prices. So the example I came up as to do with the world of sports betting. Right. So you could use this analogy to betting on soccer games today what you could do on DraftKings, all kinds of websites, or football, hockey, any sport you could think of right? Horse racing, we could talk about that remind me there's a good story about horse racing and bedding, as well. And we get to the barber and Odine story about how individuals make stock selection decisions. So I decided basketball was a good one to use because there is some actual academic research on this. So the analogy I use is related to college basketball, with Duke, which is a perennial contender for the national championship. Every year, it's ranked in the top 25. At the side of the season, it is won a bunch of national championships. Now, at the start of every season, most college teams that are good try to schedule a few what are called cupcake games, just to give their players chances to get in the routine, learn the you know the place to run and get to know each other, etc. Before they meet tougher competition. So Duke often scheduled a game against Army because they're at the time the most famous coach was a film in my SurfSki. Otherwise known as Coach K. He had coached the Army and Army we traveled down every year to Duke and they would get a big pay day, and Duke would have an easy win. So for people to bet on that game, no one in their right mind would bet on me to win that game, because they have played probably 3040 times already, and has won every single game. And they could probably play another 30 or 40 times and Duke would win every game. So however people decide to entice people to bet on them. Well, to make it an equal bet. They create what is called the point spread. So the bookies today you might think of DraftKings or a Las Vegas casino or your local neighborhood bookie. They set the initial point spread where they think they can get an equal amount of money bet on both sides, because they don't want to make bets. They want to take bets. Okay, just like Merrill Lynch doesn't care. If you make money or lose money on a stock you buy every time you trade. They're making money. They're a bookie. They just need you to trade and that's an important thing to know. The racetrack doesn't care either. Okay. So the bookies do their analysis and they think based on historical events and the team's skill sets, that AMI is likely to lose by 28 points. That's where they think an equal amount of money will come in. So the bookies set the initial spread, but they don't set the actual spread that as determined by the betters in their actions, so if a lot of money starts coming in betting on Duke, the bookies will raise the spread to 3033 34 Until money starts coming in on army until they get an equal amount of money. And then the winner has to put up maybe $110 to win 100. If you win, you get your 110 back and you get their 100. But if you lose, you lose 100 and N, not 100. So the bookies collect that $10 on the total of 200. You know, each one betting 100 plus. So that's the vigorish. Okay. So what happens is the point spread is moving based upon the collective wisdom of the markets. Now, it's very easy to determine, as we said earlier, whether Duke is going to win or not. Okay, but it's very hot. As it turns out, to beat that point spread. There was a study done on the NBA, the National Basketball professional leaves, six seasons, okay. And they took the pointspread, let, let's say, right now you have the New York Knicks are playing the Indiana Pacers. And the second round of the NBA championships. Let's say the Knicks are favored by three. Well, last night, they won by something like 20, that would be an era of 17. Okay, and then let's say they have lost by five, that would be an error of eight, and then you would average all the errors. Very rarely does the pointspread actually predict the actual outcome? But it turns out what is called an unbiased estimator of the outcome. Because the evidence from that study in the NBA of a six seasons 1000s of games, the average error, from the point spread determined by a bunch of fans betting with their hearts, not their heads necessarily rooting for the hometown team, or if betting on Notre Dame because they watch the movie about when one for the Gipper with Ronald Reagan, you know, whatever it might be, right. And it turns out the average ever was less than one quarter of one point. So there's no way to exploit that information. I mentioned what's racing earlier, so we might as well touch on well, before

Andrew Stotz 07:43
you go to that just tonight. So what you've now shown is that the accuracy was exceptional. Yep. And the second point that you're making is that just the accuracy of the average was exceptional. But then there's also points you know, there's errors, but those errors are equally distributed. Like sometimes, you're gonna get it right, sometimes you're gonna get it wrong. And so the existence of a winner or a loser, or the existence of even a big winner, or a big loser, does not mean that it's not efficient.

Larry Swedroe 08:19
Yeah, that's exactly right. My mother used to love to go God bless her love to go to the racetrack, and she always bet on number three in the first race. Why? Because she had three children. If a jockey was wearing the color purple, she hated it, she wouldn't bet on it she bet on because she liked the name of a horse. Now there are people go to the racetrack, study the charts study the form. Today, they're seeing that the horses on the inside track in the first second position tend to win. So they'll bet on in the future. Next races, they'll bet on that. They look at whether a West runs better in the mud or on a hot track. Turns out that a three to one favorite guest wins. What percentage of the time one out of every four races 30 to one favorite wins. You know, a 31 Underdog wins one out of 31 races. And these are people like my mother betting you know, on our hearts and and other things, not because they're experts. But I did find one interesting thing. The big underdogs tend to pay off worse. People love to buy lottery tickets. So even though they we know when you buy a lottery ticket in the US, the state takes about 50 cents of every dollar so every time you buy a lottery ticket, you're expected loss. The median is going to be 100% right Most of the time you lose. But the mean is minus 50 cents, but people buy him anyway. Well, that's true with betting on horses. Turns out, it's also true betting on stocks, stocks and bankruptcy. 1% of them ever pay out to investors, yet they trade in indexes, and people buy them stocks, small growth companies with high investment and low profits. They have returns worse than treasury bills. There are a small groups of these lottery like stocks that are inefficient, because investors have such a strong preference. They overpay for them. And it's so expensive and risky to go show up. As anyone who just saw what happened yesterday with GameStop. And AMC just again, the stock soared and punished the professionals who are short, and maybe customed trillions of dollars again. So let's try to sum this up here their tie this what does this all have to do with investing? All right, so Duke and army we said was the great team and the weaker team, we have Nvidia and Ford Motor, which one is Duke and which one is on? Nvidia Duke? Alright, so it's easy to identify the better company? Why do people think it's easy to identify whether the stock will do better, the equivalent of the point spread is in video, I'm just making this up might be trading at 70 times earnings. And, you know, Ford Motors trading at seven times earnings. And that's the equivalent of the point spread on a risk adjusted basis, they should be equal in their ability to provide investors with expected returns, or the market would price it differently. And we know that these P E ratios are unbiased predictors of future outcomes, because active managers persistently fail. And I'll let you cite the evidence on the fama and French paper.

Andrew Stotz 12:15
So just just under curiosity, I checked invidious trading at 50 times PE, and Ford is trading at eight times p. And so, and I just want to highlight what you've talked about here, because the first thing is that it's, it's not so much that, you know, we acknowledge that there's differences in those horses. And we acknowledge that a student better, we'll notice that, you know, in the rain, this one, you know, does better or in the inside track, this one does better, those differences exist. And there and so but it's the question is, Are you the only one who has noticed these differences? Or is it in the price?

Larry Swedroe 13:03
Yeah, and we know the markets are not 100% efficient. And we know that there is these great risks are going show up. So prices can get overvalued, it's unlikely to be undervalued, because it's easy to correct that you just buy the stock, but prices can get over value. Now you have to remember, there are clearly people who know more about sports. If you and I might been on college basketball, I think I likely know more than you first of all you lived in the US and college basketball is my personal love. I weighed a little bit at a d3 school. But watch games, any good teams are playing I don't have to really get into so I'll watch it. But so and we know that people bet with our hot sometimes and stuff. It's the thing is with stocks, you may have an advantage, you know, more or a little bit more than others when there are these inefficiencies. But is it enough to overcome your costs. You have bid offer spreads, and you have some Commission's and if you're a big institutional investor, you're going to move the market when you're a buyer. And that's just like the bookies they had taken in a bookies. You have to be right about 53% of the time, but not 51 but 53 Because the bookies are taking that vigorous out of each bed and at the racetrack the state is taking in the US about 17%. So you have to be not just better than the average better. You have to be a lot smarter to overcome those costs. That's not even taking into account Andrew, the time you're spending on in doing that investigation. Instead of spending it with your Why for your grandchildren reading a good book or other endeavors that might improve your life?

Andrew Stotz 15:06
Yeah, or, for instance, if you're still in the prime of your life, you know, creating your wealth through business, you know, is another part, one of the things I wanted to mention is that a lot of people will walk away from investing because they either lost big or they won big. And they know their experience with investing. Let's say somebody wins big. And they'll, they'll take away more meaning than is actually in that. And so again, this unbiased estimator concept is so important, because in the end, what happens is that many people, like I see it all the time when people say, Yeah, but I have this friend who has a Lamborghini that he got from investing in the stock market. So the stock market can't be efficient, Larry, well, the unbiased estimator says, Oh, absolutely a one person getting a Lamborghini out of the market is absolutely an outcome of an efficient market. We're not saying an efficient market does not say that there won't be extreme positive and negative outcomes. the efficient market says that that will be equally distributed on the plus and minus side. And therefore, when that guy goes back to make his next trade, he may lose his Lamborghini, and over his lifetime of trading, he's going to end up at zero if we don't include all the costs. That's a whole nother thing. But do I have that right, or is there anything? Yeah,

Larry Swedroe 16:37
that's basically right. I'll add a couple of little caveats here. We know from the evidence that on average, retail investors are naive or dumb money. And institutional investors are much more aware of the academic research, our smart money. Now, here's the thing. So I mentioned earlier, there are a bunch of stocks that have certain traits or characteristics, I call them lottery stocks that have very poor returns. And we know that value stocks over the long term have outperformed growth stocks, and smallest stocks have outperformed watch stocks or quality or more profitable companies have outperformed. Guess which side of the trade the naive retail investors are on. And since somebody is a buyer, someone is a seller also. And so if you look at portfolios, the retail investors and the overweight the stocks with poor characteristics, and the institutions tend to slightly overweight. The problem is only 10% of the trading is done by individuals today on their own as opposed to individuals owning mutual funds or ETFs. Run by institutions. So there just aren't enough dummies to exploit for the act of managers to win persistently.

Andrew Stotz 18:09
So this, this research you cited about from Brad Barber and Terence Odine, talks about many they've done a lot of different, great research about the behavior of individual investors, performance of men versus women, and also investment clubs and all that maybe you could just summarize what is the outcome that they found through their research?

Larry Swedroe 18:36
Yeah, well, number one is that we know and all too human characteristic is overconfidence. We tend to be overconfident about all kinds of things. Do there have been studies done on asking people if you're a better than average driver? 90% of the people say they're better than average, which by definition is impossible. Right? But two more inches. The thing is, they did a study asking people who were in hospitals involved in car crashes, where they were identified as the cause of the accident. And they still said they were a better than average driver. It showed right now, overconfidence is probably a good thing in our daily lives. Because if we looked in the mirror and said, Gee, I'm dumb, ugly, stupid, and nobody likes me, the suicide rate would be pretty high. So we tend to feel good. We think we're good looking when everyone likes us. And that helps us get through life with a better attitude. But if you're overconfident about your stock picking, what are you likely to do? One you won't diversify this. I don't need to diversify. I can figure out just a few stocks. Right. And you'll own the riskier stocks because you know, they're not risky. The market is stupid. And you're a lot smarter, right? So you will concentrate. And that's how, you know, let's say there's 100 stocks with lousy characteristics. And 100 Different people buy each one, one for each one. Well, one of them ends up with the Lamborghini and the other 99 of bankrupt. That's your example, then mean that the guy who got the Lamborghini was a genius, he got lucky. Of course, he will attribute it to skill. And the 99 will attribute it to what? Bad luck. Not right, until they eventually have enough losses that maybe they wake up and read my book and read the evidence and say, I think I ought to stop playing that losers game, right? And accept market returns, because I'm not smarter. And I have to learn whatever I think I know about the market. I just asked the question Larry taught me to ask, which is, okay, I know these things. But am I the only one who knows it? Does Warren Buffett not know it? The oil, these hedge funds not know it? And if they do, it surely isn't the price, and therefore it's too late? I should ignore it.

Andrew Stotz 21:16
And one of the questions I had about the Barbara Odine research was that, you know, they their research was done a while ago, and they did a lot of research on individual investors, when you could say individual investors probably had more stocks and less, let's say, global or, you know, broad based ETFs and stuff. And when you're looking at a person's portfolio and looking at the number of stocks that they own, and let's say we go back in time and 5030 years ago, they own three stocks. But now they may own three stocks plus s&p 500 index, does that change the way that a researcher should look at whether a person is diversified or not? Yeah, certainly,

Larry Swedroe 22:03
I thought it would depend if 90% of your portfolios in the three stocks and 10 in the s&p, you're not diversified? Well, if 90% is in the s&p and three in the three stocks, well, maybe that's your play money. But there's a couple other things we can talk about that I think are amusing stories, but provide insights, Brad Barber, and Taryn. So Dean also did a study on men and women, called the boys will be boys. And they looked at the men or women have better outcomes. Or let me ask you this first question. Were men or women better stock pickers. What do you think answer?

Andrew Stotz 22:53
I think men are better stock pickers, of course, because

Larry Swedroe 22:56
neither was a good stock picker. They both the stocks, men and women bought, and that underperformed after they bought them. And the stocks that men and women sold tend to outperform after they sold them. Because no one will ever admit that right? They only tell you the positive story and never the other ones. But here's an interesting story. Both had equally bad stock picking skills and market timing, which

Andrew Stotz 23:26
makes sense because the market is efficient, which

Larry Swedroe 23:29
is exactly right. It's just as efficient for men as it is for them. But it turns out that women actually had better returns than men. Why was that?

Andrew Stotz 23:43
risk their assessment of risk? Nope.

Larry Swedroe 23:46
Wasn't that they traded less make trading less, right? Why does men trade more? It's that testosterone factor because they were overconfident, traded more. So men have confidence in skills they don't have women know better. Right? And here's the last question on that one. Who does better married men? Or single men? Married men? Of course. Yeah. The women temper their husbands enthusiasm, or over who did better married women or single women? That I don't remember. Single women. Husbands with screwed up. Here's my

24:33
last story on this. So if I get married, that means I'm gonna have better returns.

Larry Swedroe 24:37
Yeah, I've probably.

Andrew Stotz 24:41
Now that is a good argument for getting married. No. Yeah.

Larry Swedroe 24:44
So is my last story on this subject. You would think of any group of investors would outperform it's the Mensa Investment Club. Right? Because clearly, you know, these are by definition The smartest people apply I think it's the I remember correctly, top 2% by IQ. So

Andrew Stotz 25:06
that just so everybody understands when when you get together with a group of people to decide, hey, why don't we share our knowledge and discuss about stocks and you know, really work at this and try to focus some time on it. Two heads are better than one, as we say, in America. Yeah,

Larry Swedroe 25:25
that when it comes to investing, there's all kinds of study on investment clubs. All they underperform. And which is expected because, right, the market is efficient. But the Mensa club, set a record. You know, one guy talked about, and you know, he lost something like 72%, you know, the acid in the club over the 30. Day returns were worse than T bills and that kind of stuff. You know, it was just her I forgot the exact details, but the results were terrible. They tell the market see that intelligence is not enough. Because the game is not one on one, Warren Buffett has not been able to outperform the market in almost 20 years. He's clearly a smart investor. But the game is a collective wisdom of the entire market, you're pitting your knowledge against. And that means it's a very different game than one on one, which is the subject of the next chapter in the book. Why do we see persistence in the performance of athletes, but not for money managers. And so I tried to provide an analogy. And I guess we'll do that next session. And

Andrew Stotz 26:49
one of the thing that's interesting is that many people in the stock market who are somewhat beginners and they start buying stocks, they, they really don't know what to do. So they ended up just holding, let's say they buy three or four stocks, you know, they're under diversified. And then they just hold them. And when they look at their friends or other people that they see trading in the market, who are constantly telling you about how they bought this, and they sold that than they bought this and then they're trading a lot. This research showed that actually, what happens is that people who are trading a lot, underperform the people who are trading last. This is in for individual investors, let's say retail investors by about 10%. Yeah, that was

Larry Swedroe 27:32
bad. It's even worse than that real In a related story. To that, well, it should be expected. The more you trade, you're incurring trading costs, I bid offer spreads. For example, if you buy even ETFs and trade that spreads between the bid and offer, it can be significant. Even if you think it's permissionless trading. As they say BS, yeah, there's no commission, but you could pay a better and you're never going to get an efficient price. Because the market will, you'll buy above the nav, and you're gonna sell it below the nav, because the arbitrage yours will be on the other side. Okay. And so you're always going to lose a little bit. Now, it may be a very minor number, and things like an s&p 500 index ETF. But in a small cap and emerging markets, sector funds, the spreads can be quite wide. And that is especially true in markets where it's moving rapidly because there's news coming out there after a GNP reporter and inflation number, the spreads can actually get very wide. So it's a problem.

Andrew Stotz 28:48
There's two last research papers that you cite in this chapter. The first one is fama and French talking about? They found that only managers in the 98 to 99th percentile showed evidence of statistically significant skill. And the other one was similar results were found by Philip Myers Braun and his study mutual fund performance through a five factor lens. Importantly, the research consistently finds that there is no persistence in performance beyond the randomly expected. Can you just wrap up this discussion, I mean, fama and French is, you know, a seminal seminal research that's being done there. In theory, it should have decimated the the industry and you can say it did to some extent where passive funds became now almost 50% of the overall industry, but maybe you could just talk briefly about

Larry Swedroe 29:39
those. Yes, let's go back when I wrote my first book in 98. At that time, Charles Ellis wrote a much more famous book winning the losers game. And he found about on a pre tax basis 20% of active funds were outperforming their benchmark after taxes is probably 10%. That's still a big time losers game, especially for taxable investors. I don't like playing games where there's a 90% chance of losing fama and French then come along 12 years later. And the market has become much more efficient over that time, because of published research showing that there are certain types of stocks that have characteristics of higher returns. And now you can't claim alpha because, you know, you're buying stocks that are more profitable with momentum and things like that. Before that, there was no research and you could claim alphas no more. So this is the subject of, you know, Warren Buffett, how did he beat the market? We know today, it's not because of stock picking. But 60 years before the academics discovered things, he figured out what are the characteristics of stocks you want to buy, and even told people buy cheap, high quality profitable companies? Alright, so that means value stocks that are profitable, don't have a lot of financial or operating leverage, and you will outperform Okay, fama and French fam, that took less than 2%. And that has been duplicated. Now randomly, over a long period of time, if you just flip coins, for example, did it 10 times somebody out of 1000, people will flip 10 heads in a row with some group of people will do it. But that doesn't mean they're as skillful. You say that heads flips when that doesn't mean they're skillful. We randomly should expect, right? We do. They have 10,000 people, if the one round, they have 5002, rounds, 20 503, rounds, 1250, you know, etc. And maybe if 10 Winners after 10 rounds? Well, you're not going to bet on them to win the next round, the only way you would do it, if you found that there were like 100 of these people. Maybe there was a skill in flipping the coin was a coin wasn't fair, right? Well, fama and French found the actual number was less than you would randomly expect.

Andrew Stotz 32:20
So explain that for a second, because he's what you say is Fama, French found that only managers in the 98 and 99th percentile show evidence of satisfactory significant disease equally significant wouldn't have been what would about the same number, let's

Larry Swedroe 32:37
say maybe we would expect two or 3%, right? So there was no difference, right? You randomly you would expect in any one year 50%, if the markets are before costs, you know, 50% should beat the market. After two years, you know, then it should be 25%, you'd be two years in a row, and then 12%, six and a half, three, you know, et cetera, right. And they found that's what you should expect randomly once you adjust for these factor exposures. And s&p has reported the same thing. They just came out with the 2023 Stiva report, and I looked scans it through. And basically, if you just read the headlines, it says fewer than the randomly expected number of active managers repeated in the top quintile in the last five years, or whatever they looked at, right? And stuff. So that's the problem. And let me add one other thing I was gonna mention, we mentioned the more you trade, the worse you tend to do. Okay. They also the research has found the more you look at the value of your portfolio, the worse you do, why is that injured?

Andrew Stotz 33:58
Because you're you're going to trade,

Larry Swedroe 34:00
you're gonna Yeah, there's, there's only two things you could do when you look at your portfolio, do nothing or if it cause you to act. Well, if it causes you to act. Acting is bad, because you have more cost. You're better off being a Rip Van Winkle investor, just be globally diversified, use low cost passive factor base funds, and you will likely outperform the vast vast majority of professionals, if you have the discipline to stay the course and rebalance along the way. So you're better off being a Rip Van Winkle investor and not check. Don't watch Cramer on CNBC. Don't listen to what these guys have to say. They don't know anything more than the market is already priced in.

Andrew Stotz 34:49
And just one last thing that I want to highlight is the fact of based analysis that was developed by fama and French originally, I think we're the ones that brought Got a group of factors, the three factors together? Basically, if I, if I understand it correctly, from that moment on, no one could then claim, you know, it would be harder to claim outperformance because basically, what you could then do is you could say, well, wait a minute, small cap companies outperformed during that period. And you were overweight in small cap companies. And I could have gotten that exposure, either by building a portfolio of small cap companies, or I could have by a small cap fund or ETF to get that exposure. And it is that how does that all come together in the way we think about it now? Yeah, I

Larry Swedroe 35:41
let me think I can explain it and have a little bit to be helpful here. So prior to fama and French, right, publishing their famous paper, the court section of expected returns, if you bought value stocks, there was no model other than the cap n the capital asset pricing model, which is a single factor, market beta factor, which is close to the Think of it as volatility relative to the market's volatility. So if you bought cheap stocks, value companies, low P E, low price to book low price to cash flow, and you beat the s&p 500, that was alpha, you could claim you outperform after nine da or after the 90 to three when that was published, you can't do it anymore. You could claim it. But a research will say, Well, let me run your portfolio through my factor model. We'll say, you know, we'll account for your exposure to these value stocks. And now if you show excess returns, then you're a skillful stock picker. If not, then you would just loading up on these factors. So that factors are explaining like 92% of the variation in return. So explain the vast majority different today. We're up to like 98%, because we have a few other factors there. But let me add one thing, just to clarify your point. So if you bought small stocks, and over the long term, small stocks outperform you can't claim it anymore. You could before 90 to three. But if you bought an overweighted small stocks, when they were outperforming, and underweighted them when they were underperforming, then you could claim skill, right, because you had different weightings at the right times. So your exposure varied at the right times, that would show skill, but we don't find evidence of that. That's the problem. We don't find evidence that people shifting their strategies and exposures to market timing. That would be market timing. Yes. They're factor exposures may change, but they don't change at the right times.

Andrew Stotz 38:11
And ladies and gentlemen, that is how markets set prices. Larry, I want to thank you again for another great discussion about creating growing and protecting your wealth and for listeners out there who want to keep up with what Larry is doing. Find him on Twitter at Larry swedroe. And also on LinkedIn. This is your worst podcast, Jose Andrew Stotz saying, I'll see you on the upside..