Religion and Stocks…What Do You Believe In?
Nov 24th, 2008 by Carlos
by seanmcgrath
I’m afraid this is one of those posts where you read the title and say to yourself, “Oh boy, what was this guy thinking writing a post about religion?!” And then you start getting into the post and you realize he’s done a bit of playing around with the words in the title of his post just to lure you in, because the post isn’t really about religion, but about how something similar to religion exists in the world of investing. So if you feel tricked or fooled (or bamboozled) then I’m sorry but at least I’m telling you all this right up front, right? So doesn’t that kind of make up for the sleight of hand and warrant a “Well, maybe I’ll check out what he wants to say after all?” Doesn’t it?
There are two broad schools of thought when it comes to investing and how the market works. It’s impossible to say one is right and the other is wrong—no one can say for sure. People on both sides defend their theory with staunch ferocity, and there is oftentimes a fair bit of name calling from one side to the other. Let’s take a look at why investors and theoreticians are behaving like theologians.
Efficient Market Theory
This theory basically says that the stock market is a perfect weighing machine for public companies. There is a whole bunch of information out there and the market takes all of it into account. In other words, there’s nothing you can do to exploit this huge machine because the market is so fast and efficient that it has all the rumors, speculation, and actual numbers baked into the prices of the stocks that belong in it. So if you hear a rumor about a company possible getting this new patent approved and you’re thinking of buying that stock…forget about it. That rumor has already been taken into account.
Sound boring? It is. This theory might appeal to people who believe in fate and want to resign themselves to doing nothing because—well, it won’t matter. The market will do what it has to do and there’s nothing you can do about it. That means that picking stocks is little more than gambling, although you could rely on things like consumer sentiment to guide your decisions.
“Wow, so many people are buying these iPods now, maybe I should invest in Apple because of it.”
With the Internet and all the whatchamagadgets that are out there today, it’s easy to be tempted into becoming an EMT-ite.
The “Other” Theory
I’m not sure what this one is called, but it’s the side that famed investors like Warren Buffett and Peter Lynch fall on. It’s also the side that all those books with titles like “Pick Stocks Like Pro!” and “Beat the Market!” fall on, unfortunately.
This side claims that the market is NOT efficient. Stocks go up and down based on the same stuff that EMT relies on, only that here the investor can exploit these inefficiencies by examining the numbers behind a company. If you have the patience and the stamina to wade through LOTS of numbers, this theory believes that you can make it pay off big time.
“Wow, Johnson & Johnson is trading at a very low P/E ratio right now and their books look solid, I should invest in it.”
If you’re ever read The Intelligent Investor—(or any of the other books that mention it) the bible for this side of the argument—you’re probably heard of the term Mr. Market. Mr. Market will quote you a price every minute of the day for a given stock, but sometimes he’ll go off on these wild, moody swings that you can take advantage of. Another book I’ve read that falls squarely in this camp is Rule #1 (check out my book store for other books worth checking out).
Which is Best?
Impossible to say. But both theories bring something interesting to the table. If you believe in EMT, how do you explain Warren Buffett? Luck combined with his penchant for buying and influencing the management of certain companies? Luck alone? If you’ve done any investing at all, you know that luck eventually runs out and Warren is still going strong.
I’m not sure where I fall on the spectrum, but my man crush on Warren Buffett probably puts me square in that second group. Lately I’ve been re-examining this though, and the idea of not looking at all those numbers and trying to create meaning out of them is pretty tempting…
Then again, I love wading through baseball stats and making my opinions based on them…if only P/E ratios and balance sheets were as interesting as OBP and WHIP.
EMT is the theory most everyone should subscribe to. Buffet and Lynch have an ability that is unique to them. Because we can’t see this ability, we think we can mirror it.
Compare Buffet to LeBron James, arguably the future of the NBA and one of the best basketball players in the world. You see his speed, his power, his agility, and abilities. You know you can’t physically do what he does, so you don’t try and go pro with your b-ball.
But Buffet is just some old white guy who bought stocks in brands he liked. He made a bunch of money, so you thought you could too.
I’m guilty of buying a stock here and there, but it’s mostly for fun. Just like I’ll play ball at the YMCA.
There is a reason Buffet endorses index funds, it’s because he knows his skillset is unique and the vast majority of people cannot do what he does. I would follow his advice, long before I follow his investing strategy.
Just like LeBron James will tell you to go to college, even though he didn’t.
PS: P/E ratios will always be more interesting than ANYTHING associated with baseball. Football is another thing…
When I first heard about EMT in college I knew it was bunk, and the longer I spend in the markets I more convinced I am of that fact. Efficient markets rely on perfect distribution of information and rational decision-making. The information part of it has certainly moved in that direction, but traders still get (and act) on information at a dispersed periods of times. As for rationality, one needs only to look at the behavior of prices over the last year or so for rejection of that idea.
Markets tend toward efficiency when they are at low volatility and the information flow is light. The faster things are moving, the less efficient the markets become.
I totally agree that the whole idea of “Warren did it, I could too!” is far fetched. I invest around 90% of my money in index funds, but I have to feed that greedy/stupid part of me that thinks he can do better than the market! I only own a couple of stocks (and one of them is Berkshire Hathaway), but I still think that having a stock or two (or at least entertaining the possibility of buying some) is a good idea. It keeps you paying attention to what’s happening in the world of finance and how stocks move up and down depending on economic conditions, earnings reports, etc. If I only owned index funds, I might not pay attention to any of that stuff.
Which might actually save me a lot of stress, now that I mention it….
weakonomist – What you are talking about is the complete opposite of Efficient Markets. The EMH says skill or talent cannot create outperformance (only luck). This is not to say, however, that I disagree with your general suggestion that most folks are probably best off with index funds.
I’m with John. I say that the Efficient Market Theory is 100 percent myth, 100 percent gibberish.
I like it that he also says that most people should be in index funds. That’s also true.
What’s happened is that the Efficient Market Theory proponents came up with an explanation for why most people do a poor job of picking stocks and people noticed that it is true that most people do a poor job of picking stocks and jumped to the conclusion that the Efficient Market Theory is right. No! There are perfectly logical explanations for why most people do a poor job of picking stocks that do not require a belief in the Efficient Market Theory.
Investing is a highly emotional endeavor. Most people get caught up in the emotion. Warren Buffett doesn’t. That’s his secret. Anyone of average intelligence can pick stocks effectively IF he first devotes a lot of effort to getting his emotions under control. That’s a big job.
The great irony is that Efficient Market Theory proponents are the most emotional investors of all. The author is right to compare belief in this theory to belief in a religion. I have nothing against religion (I am a believer myself) but I do have something against intense dogmatism. I have never seen in any other area of life the intense dogmatism that I have seen among advocates of the Efficient Market Theory. They say with their words that they are unemotional. Their arrogant disregard for other viewpoints tells a different story.
Rob