More On General Market Efficiency

It's very difficult for any single individual/entity to beat index returns. For anyone who has some money set aside, the advice, "Put it in an index fund" is sage. Very few mutual funds beat index returns in a given year. Over many years, almost none do. The average investor does not have access to inside information. The stock price moves within seconds in response to any information made public. If someone sees an incongruity or arbitrage opportunity, many others have probably already seen it and have already acted on it. "What makes you think you can beat the market?" is a good question.

It is also a question which I don't think is applied enough.

I was hanging out with some friends in Boston a few months back, and the crowd included friends of friends who I was meeting for the first time. During a conversation, one individual said that he was part of a club that engages in venture capital funding. I was surprised to hear this since he made as much money as I did, i.e., he probably didn't have money to throw around. My Hansonian leanings quickly concluded that he was merely trying to signal that he's ambitious and a "wheeler and dealer", a conjecture buttressed by the presense of several young ladies listening to our conversation. "What makes you think you can beat the market?" echoed in my mind. "What gives you that added edge to analyze fledgling companies better than the pros? Why do you think you can succeed where so many others fail?" were questions I didn't ask.

Vinod Khosla made a living funding fledgling companies through Kleiner, Perkins, Caufield and Byers. Presumably they were successful. But did they beat market returns? If so, they beat the odds. They're up against the same challenge the rest of us are: a market that incorporates knowledge very quickly. If he saw an opportunity, many others likely did too.

In the general economy, if I think of a new idea for a product, chances are someone has already thought of it. If I think of a new marketing tactic, chances are someone else has already thought of it. Instead of investing in starting a new business, why shouldn't I just put the money in a stock market index fund? Why should anyone start a business?

For someone with some money saved up, why should he do anything (like investing in individual stocks, investing in commodities, funding fledgling companies, starting a new business, loaning it out, etc) other than invest in an index fund?

I suppose the only good answer is, "Only if he wishes to take on a different risk profile than that involved with owning an index fund."

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It is people who think like you...

That leave dollar bills on the sidewalk for those willing to look.

In the S&P 500, asymmetric information is illegal to use. In more general business applications, asymmetric information is what gives these people their returns.

Your friend in Boston might just be signalling, but he could also be monetizing the networks of his ambitious friends.

A new marketing strategy might have been thought up by someone else, but that doesn't mean that it won't produce returns above those otherwise expected in an industry where they haven't been tried before.

With the right idea, the right network of people and the right operational approach new business ideas can have much larger than "index fund" expected returns.

Markets are not perfect processes. The caricature of libertarians is that they think markets are so perfect, so pointing out a market failure proves that libertarianism is wrong. Taking the efficient market view to the level above is playing along with that caricature.

The full joke

In case you haven't heard the joke Agent00yak is referring to:

An investor is walking along and says to his economist friend, "look, there is a $100 bill on the sidewalk". The economist dismisses it without looking, because according to the EMH if it was there someone else would have already picked it up.

On Efficient Markets and Entrepreneurs

In the S&P 500, asymmetric information is illegal to use. In more general business applications, asymmetric information is what gives these people their returns.

And not just asymmetric information, but asymmetric ability.

Recall that market prices reflect something about the marginal investor. To the extent that your characteristics – knowledge, ability, whatever – differ from the marginal investor’s, you can exploit that difference. Indeed, it’s generally beneficial that you do.

Whether or not you believe in the Efficient Market Hypothesis in general, there’s some sentiment that stock markets, bond markets and commodities markets are administered efficiently. Nevertheless, I understand that entities willing and able to acquire stocks, bonds, commodities in large quantities can secure better deals than the rest of us. Ability, not just information, counts.

More generally, if your knowledge and ability about any given market niche is sufficiently superior to the knowledge and ability of others, you can and should act on that. So if you have a comparative advantage in studying tax regulations and completing government forms, you may be able to open a tax preparation service that will provide you with better returns (adjusted for risk, etc.) than a stock market index.

This dynamic is precisely what makes markets valuable: Capital markets, for example, are intended to distribute resources to where they will provide the highest expected returns (adjusted for risk, etc.). Every time someone finds his comparative advantage, his way to achieve higher-than-market returns, he benefits himself. And he is likely willing to raise capital to exploit his advantage (e.g. Borrowing funds at 10% to expand his tax-preparation business that provides him with a 20% return). But in so doing, he helps to bid up the cost of borrowing. That is, he influences the characteristics of that “marginal investor.” I’m no entrepreneur. Let’s say I keep my money in nice, secure CDs. Yet the rate of return I get on my CDs is influenced by the fact that some entrepreneur somewhere discovered that he could earn a 20% return by filing other people’s taxes. Efficient markets permit me, the passive investor, to benefit from someone else’s active entrepreneurship. Indeed, we count on each other.

That’s the systemic analysis, and I believe it. This analysis, however, has very little relationship to what actually motivates people to start a business. I suspect that topic is more heavily influenced by psych than econ.

I subscribe to the view that people who start businesses do so because they have a predisposition to start a business. We can yak on all we like about how government policies will have this or that effect on promoting new businesses, and how “burdensome regulation will destroy the business environment,” yadda yadda. Yet even in the most repressive environments – slavery, concentration camps, prison yards, war zones, communist nations – entrepreneurs emerge. Bad policies clearly slow these people down. But almost nothing stops them; they can scarcely stop themselves.

HOW perfect?

Markets are not perfect processes. [It is a] caricature of libertarians is that they think markets are so perfect....

Shifting the focus from perfectly efficient markets to perfectly efficient firms:

The US Telecommunications Act of 1996 introduced competition into the market for local landline phone service. Alas, during the prior decades of state-sanctioned monopoly, the incumbent Bell firms had acquired such huge economies of scale – especially in its investment in wires to people’s homes – as to render most forms of competition impossible. Consistent with antitrust law precedent, therefore, the Telecom Act requires the incumbent firms to permit competitors to lease access to certain essential facilities at cost.

So, what do these facilities cost? The incumbent companies point to their financial books and receipts, etc., but do those documents reflect an efficient cost? The incumbents are monopolists, after all, and monopolists are famously inefficient operators. Instead, telephone companies – incumbents and competitors – develop detailed computer models for how much it should cost to run an efficient local phone company, and consequently how much of that cost should be associated with the use of any given component of the plant.

And the models must address this question: HOW efficient can we realistically expect a firm to be? Sure, it would be nice to imagine a world in which you incurred no cost for insurance, or for having excess inventory around, or underutilized staff hanging around to cover emergencies. It would be nice to imagine that every piece of equipment was designed with exactly the capacity you require so you’d never need to pay for anything with more capacity than you need. But in the real world, real firms incur real costs to cover the real fact that things don’t fit perfectly, plans go awry, and we need to have a little fat in the system/play in the joints to accommodate contingencies.

Yet the models are capable of calculating costs that reflect the hypothetical perfect world. How much fudge factor should you then tell the models to incorporate in order to calculate the cost that a REAL firm would incur to provide a given type of plant? Barrels of ink are expended on this question.

Private equity only appeals

Private equity only appeals to people who can make substantial investments and take large risks for a long period of time, therefore it might be underfunded and you would expect higher average returns. Also market are only second order efficient. If there is a cost to identify good startups and superior insight allows you to do it at a lower cost, you should expect to receive higher returns as well.

But yeah, generally, you should only invest in private equity when you already have sizeable long positions in the market.

A different take on the markets

There is another factor to consider in the markets - social mood. And here is another take on the Efficient Market Hypothesis, along with that alternate explanation for how markets move.