Enrich Your Future 02: How Markets Set Prices

In this episode of Enrich Your Future, Andrew and Larry Swedroe discuss Larry’s new book, Enrich Your Future: The Keys to Successful Investing. In this series, they discuss Chapter 02: How Markets Set Prices.LEARNING: Invest in passively managed funds and adopt a simple buy, hold, and rebalance strategy. While gamblers make bets, investors let the markets work for them, not against them. “The only way to beat an efficient market is to either know something the market doesn’t—such as the fact that a team’s best player is injured and will not be able to play—or to be able to interpret information about the teams better than the market (other gamblers collectively) does.”Larry Swedroe In this episode of Enrich Your Future, Andrew and Larry Swedroe discuss Larry’s new book, Enrich Your Future: The Keys to Successful Investing. The book is a collection of stories that Larry has developed over the 30 years or so that he’s been trying to help investors. Larry is the head of financial and economic research at Buckingham Wealth Partners. You can learn more about Larry’s Worst Investment Ever story on Ep645: Beware of Idiosyncratic Risks.Larry deeply understands the world of academic research and investing, especially risk. Today, Andrew and Larry discuss Chapter 02: How Markets Set Prices.Chapter 02: How Markets Set PricesIn this chapter, Larry explains how markets set prices—probably the most important thing investors need to learn before they invest a penny. Without this knowledge, investors won’t know whether the stock they buy is undervalued or overvalued. Larry insists that investors should have a good understanding of how the market gets to a specific price.Point spread bettingTo explain the complicated concept of how markets set prices, Larry uses an analogy related to college basketball backed up by academic research. Duke is a perennial contender for the national championship. Every year, it’s ranked in the top 25. At the start of every season, most college teams that are good try to schedule a few of what are called “cupcake” games to give their players a chance to get in the routine, learn the plays, get to know each other, etc., before they meet tougher competition.Duke often scheduled a game against Army. Army traveled down every year to Duke, where they would get a big payday, and Duke would have an easy win. No one in their right mind would bet on Army to win that game because they have played probably 30-40 times already, and Duke has won every game. And they could play another 30 or 40 times and win every game. However, people decide to entice others to bet on Army.To make it an equal bet, they create a point spread. The bookies set the initial point spread where they think they can get an equal amount of money bet on both sides. The bookies do their analysis and set the initial spread, but they don’t set the actual spread, which is 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 until money starts coming in on Army until they get an equal amount of money. Then, the winner has to put up $110 to win $100. If they win, you get their $110 back and the bookies’s $100. But if you lose, you lose $110, not $100. So the bookies collect that $10 on the total of $200. So, what happens is that the point spread is moving based on the collective wisdom of the markets.It’s very easy to determine whether Duke is going to win or not. But it’s tough to beat that point spread. Very rarely does the point spread predict the actual outcome. However, it is an unbiased estimator of the outcome. An “unbiased estimator” is a statistic that is, on average, neither too high nor too low. Evidence from a study covering six NBA seasons shows that the average error was less than one-quarter of one point. So, there’s no way to exploit that information.In terms of investing, Larry gives an example of when you want to buy a stock (making a bet on the company), you have to buy it from someone. A stockbroker will not sell that stock to you because he might lose money. Instead, they find someone who wants to sell the stock and match the buyer with the seller. He is taking bets, not making bets. In the process, he earns the vigorish (a commission). Like stockbrokers, bookies want to take bets, not make them. Thus, they set the initial point spread at the “price” they believe will balance the forces of supply and demand (the point at which an equal amount of money will be bet on Duke and Army).How to beat an efficient marketA market in which it is difficult to persistently exploit mispricing after the expenses of the effort is called an “efficient” market. According to Larry, the only way to beat an efficient market is to either know something the market doesn’t—such as the fact that a team’s best player is injured and will not be able to play—or to be able to interpret information about the teams better than the market (other gamblers collectively) does.The existence of an efficient public market in which the knowledge of all bettors (investors) is used to set prices protects the less informed bettors (investors) from being exploited. On the other hand, the existence of an efficient market prevents the sophisticated and more knowledgeable bettors (investors) from exploiting their less knowledgeable counterparts.Since about 90 percent of all trading is done by large institutional traders, these sophisticated investors are setting prices, not amateur individual investors. The competition is undoubtedly tougher, with professionals (instead of amateurs) dominating the market. Every time an individual buys a stock, he should consider that he is competing with these giant institutional investors. The individual investor should also acknowledge that institutions have more resources, and thus, they will likely succeed.However, study after study demonstrates that the majority of individual and institutional investors who attempt to beat the market by either picking stocks or timing the market fail miserably, and they do so with great persistence.A study by University of California professors Brad Barber and Terrance Odean found that the stocks individual investors buy underperform the market after they buy them, and the stocks they sell outperform after they sell them. They also found that male investors underperform the market by about 3% per annum, and women (because they trade less and thus incur less costs) trail the market by about 2% per annum. In addition, they found that those investors who traded the most trailed the market on a risk-adjusted basis by over 10 percent per annum. And to prove that more heads are not better than one, they found that investment clubs trailed the market by almost 4% per annum.Betting against an efficient marketBetting against an efficient market is a loser’s game. It doesn’t matter whether the “game” is betting on a sporting event or trying to identify which stocks will outperform the market. While it is possible to win by betting on sporting events, because the markets are highly efficient, the only likely winners are the bookies. In addition, the more you play the game, the more likely you will lose, and the bookies will win. The same is true of investing. And the reason is that the securities markets are also highly efficient.If you try to time the market, pick stocks, or hire managers to engage in that activity for you, you are playing a loser’s game. Just as you can win by betting on sporting events, you can win (outperform) by picking stocks, timing the market, or using active managers to play the game on your behalf. However, the odds are poor. And just as with gambling, the more and the longer you play the game, the more likely you will lose (as the costs of playing compound). This makes accepting market returns (passive investing) the winner’s game.Larry advises investors to invest in passively managed funds and adopt a simple buy, hold, and rebalance strategy. This way, you are guaranteed to earn market rates of returns at a low cost and relatively tax-efficient manner. You are also virtually guaranteed to outperform the majority of professional and individual investors. Thus, it is the strategy most likely to achieve the best results. The bottom line is that while gamblers make bets (speculate on individual stocks and actively managed funds), investors let the markets work for them, not against them.Further readingWilliam J. Bernstein, The Four Pillars of Investing (McGraw-Hill, 2002).Raymond D. Sauer, “The Economics of Wagering Markets,” Journal of...