To help them make better decisions, experts develop models for their fields. Usually, these models represent the questions as researchers ask them. Unfortunately, however, the way a researcher asks a question is assumed to be equivalent to the way that a non-expert would. A lot of tension then develops between experts and the lay public. The experts do not understand how the lay public can’t see obvious truths and the lay public wonders, why bother with experts in the first place?
One belief commonly held among experts is that “You can’t beat the market.” Now, obviously some people do beat it, but the experts are not trying to deny that. Their point is that the market yields an average return.
If you beat the average return of the market, it means that someone else got beaten by it. So “you can’t beat the market” means that, on average, everyone together will wind up with average returns.
Let’s say I tell you, “Here’s a great system. Use this system and you will beat the market.” Let’s allow that my recommended system performs well. If other people find out about the system and everyone uses it, then it will no longer “beat the market” because the market is now using the system!
That is the expert view—dry, mathematical, and essentially irrefutable. However, there is a deeper truth that the expert’s way of analyzing the question misses.
As an investor, you are part of the market. The idea that “you can’t beat the market” is too pessimistic because it assumes that the market will do nothing whatsoever about your presence there. While it is true that the market will probably not move significantly for a single person with a small bank account, it may in fact move for many individuals acting in similar ways. And, what I am referring to is not just the price of stocks.
Let’s say that a large group of investors decide that they prefer to put their money into stocks that have a strong balance sheet and generate dividends. Their decision means that money will flow away from companies with weak balance sheets that don’t offer a dividend toward the ones that do. Shareholders at the companies that are now out of favor will notice the trend. They will recognize that if they want new investors, their companies must behave differently. They will install a board of directors that acts on those wishes and the company will change direction, according to the wishes of the investing public.
Investment bankers will notice this as well and they will wait to put up a company for an IPO (initial public offering) until it has a stronger balance sheet and produces a dividend. Likewise, early-stage entrepreneurs who are looking for a public exit will build this strategy into their plan.
On the other hand, let’s say that a large group of investors decide to put their money into long-term ventures with a small percentage chance of victory but a very heavy payoff. Again, their decision prompts companies to start focusing on research and development for future products. It influences the investment bankers, who will then look for IPOs that are future-focused. It also influences entrepreneurs looking for a public exit.
However, let us say that the market as a whole decides that it “can’t beat the market.” What happens then? If investors as a whole decide that they can’t beat the market, it means that there will be less examination of the fundamentals of a company, less fact-checking on what executives say, less skepticism of grand claims, etc. If “you can’t beat the market,” why try? Just invest in a broad spectrum and hope for the best.
But what happens then? Well, investment bankers are often paid on the basis of bringing new products to market. If people don’t care about the quality of their investments, then the investment bankers are incentivized to just bring a larger quantity of potential investments into the market. Their approach means that lower quality companies will show up on the stock market. In turn, early-stage entrepreneurs will be more concerned about jumping the right hoops than about building a solid business. And the stock market as a whole will suffer.
In such an environment, by blindly betting on the market through index funds, you may prevent your neighbor from getting a leg up on you. But both you and your neighbor will be worse off on the whole because the quality of the goods inside the market will weaken over the long term if nobody is judging them by any standard of value.
So, if “beating the market” means, “getting more than my neighbor,” it is true that you probably can’t beat the market. However, if by “beating the market” means “the market as a whole (me included) will generate better returns through my involvement,” then you can indeed beat the market. The market with you may in fact be better than the market without you.
Trying to do better than our neighbors is a product of envy. But using our talents to identify and invest in high-quality assets and pull money away from low-quality assets is a benefit to everyone involved in the market and, on the larger scale, the market’s future. If you invest in this way, you will beat the market. It will be a better, more profitable market with you involved actively rather than only passively and the returns of the entire market will likewise be better than they would otherwise have been.
If you enjoyed this piece by Jonathan Bartlett, you may want to look further into the relationship between markets and information theory with him. Some surprises may be in store…
How can information help the economy grow? New information is the true source of new wealth; everyone wins when we learn how to produce it more efficiently.