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— Girolamo Cardano, 16th-century physician, mathematician and quintessential Renaissance man
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Jay and Haden were having lunch one day, and the topic turned to the stock market.
Haden: I just bought 1,000 shares of Apple.
Jay: Why did you buy Apple?
Haden: I became interested when I heard a fund manager on CNBC yesterday recommend the stock. He gave a solid explanation for the recommendation. I went home and did my own research; I don’t just rely on the recommendations of others. I found the company has a stream of new products in the pipeline that are expected to drive the growth in earnings to a much higher rate. The iPad and Mac installed bases are attracting new users, and growth continues to outperform expectations. Margins are improving. They saw new all-time revenue records in the App Store, Apple Music, video and cloud services. And despite large share buybacks, their balance sheet is very strong.
Jay: Those all sound like good reasons for buying the stock. However, in the end the only logical reason for your purchasing it was that you believed it had a high likelihood of outperforming the market. This must be so because owning just one stock is taking more risk, because of the lack of diversification, than if you’d purchased a total stock market index fund. Isn’t that correct?
Haden: I guess so, if you look at it that way.
Jay: That’s the only way to look at it. At least, the only correct way. Now, Haden, where did you get those shares?
Haden: I bought them through a brokerage firm, of course.
Jay: That’s not what I meant. What I meant was, where did the shares you purchased come from? They didn’t come out of thin air. Someone had to sell them to you. The market has two types of investors: individuals like you and me, and institutional investors such as pension funds, mutual funds and hedge funds. Do you believe the seller was more likely another individual investor like you? Or was the seller more likely one of those institutional investors?
Haden: I would guess the seller was another individual investor.
Jay: That’s incorrect. Since today institutional investors do about 90 percent of all trading, there’s about a 90 percent chance the seller was an institution. Since we now agree the underlying reason you bought the stock was that you believed it would outperform the market, we can also agree the underlying reason the institutional investor sold the stock was that it believed the stock would underperform the market. If that were not the case, it would have continued to hold the stock. Correct?
Haden: I guess so.
Jay: Okay. You believed it would outperform the market, and the institutional investor believed it would underperform. How many of you can be correct?
Haden: Just one.
Jay: If you’re being perfectly honest with yourself, who do you believe had more knowledge about the company—you or the institutional investor?
Haden: I’d have to say the institutional investor.
Jay: I agree. Thus, all the reasons you gave me for buying Apple were also known to the institutional investor. What you thought was was really nothing more than that other, more sophisticated investors also had. Yet, the institutional investor decided to sell the stock. So the logical question is, why did you buy the stock knowing there could only be one winner in the trade, and you were likely the loser?
Haden: I never thought about it that way.
Jay: Again, that’s the only right way to think about it. You’re playing a game where there can only be one winner, and you’re playing with a competitive disadvantage. The most likely way to avoid losing that type of game is to not play. What I believe is the most interesting part of the game of trying to beat the market lies in the answer to this question: Who is the likely seller when one institutional investor buys? Is it an individual investor or another institution?
Haden: Since institutions do as much as 90 percent of the trading, the logical answer is that the seller is another institutional investor.
Jay: Correct. One institution bought, say, one of Goldman Sachs’ mutual funds because it thought the stock would outperform, while the other, say, one of Morgan Stanley’s mutual funds, sold because it thought the stock would underperform. Which is right?
Haden: Obviously, only one of them.
Jay: Now, which of them is spending your money, in the form of the operating expense ratio, commissions and other trading costs, in the effort to outperform the market?
Haden: Both of them.
Jay: That’s why active management is a loser’s game. Since outperforming the market must be a zero-sum game the expenses of the effort, in aggregate, expenses it must be a loser’s game for investors. Collectively, active investors must underperform the market by the total of all their expenses. Since most of the competition is between very sophisticated and knowledgeable investors, it’s hard for them to find enough victims — meaning people like you and me — to exploit in order to overcome the hurdle of their expenses. So Haden, with your newly found insight, would you still have made that trade?
Haden: I see why it really doesn’t make sense. I see it’s likely I’ll only “discover” information these institutional investors already know. Therefore, that information is already built into the current price.
Jay: Now you see why I never buy individual stocks. I don’t like playing a game where the odds are stacked against me. And more importantly, I have far more important things to do with my time than researching stocks—like spending time with my family.
Haden: Well, I know my wife would agree with you on that.
The findings of a study by Brad Barber and Terrance Odean support the logic of the above tale. They found the stocks individual investors buy underperform the market they buy them, and the stocks they sell outperform they sell them.
Barber and Odean found the same results when they studied the performance of investment clubs. Since there must be another side to every trade, we can conclude that when individuals and investment clubs trade, institutional investors are exploiting them. Unfortunately for the institutional investors, since they do as much as 90 percent of the trading, there just aren’t enough Hadens to exploit to overcome the expenses of their efforts.
The moral of the tale
Individual investors should never make the mistake of confusing information with knowledge. The way to avoid that mistake is to remember the following. Every time you hear or read a recommendation on a stock or asset class (such as small caps or emerging markets), ask yourself this question: “Am I the only one who knows this information?” If the answer is no (it is, unless it’s inside information, on which it’s illegal to trade), the market has already incorporated that information into prices — and the information cannot be exploited.
Insight is not sufficient. You can only benefit if other traders don’t have the same insight. Unfortunately, valuable information about a company, asset class or market has no value because it cannot be exploited, at least legally — as Martha Stewart learned, to her regret.
And finally, perhaps the most amusing thing about the stock market is that for every buyer, there must be a seller, and both believe they are doing the right thing. Each believes he is somehow smarter than the other. However, the stock market isn’t Lake Wobegon, where everyone is above average.
1. Brad Barber and Terrance Odean, Trading Is Hazardous to Your Wealth: The Common Stock Investment Performance of Individual Investors, Journal of Finance (April 2000)
2. Barber and Odean, Too Many Cooks Spoil the Profits: Investment Club Performance, Financial Analysts Journal, Volume 56, Issue 1, 2000