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Evidence-Based Investment Insights: Part I



Welcome to the Market

Are you ready to become a better investor? Would you like to enhance your understanding of the most important principles that drive the creation of wealth, without it hurting a bit? In this and the next two issues of our e-newsletter, we will introduce three essentials on how to invest with evidence instead of emotion guiding your way. You see, being a better, evidence-based investor does not mean you must have an advanced degree in financial economics, or that you have to be smarter, faster or luckier than the rest of the market. It means three things:


1.     Knowing and heeding the evidence from those who do have advanced degrees in financial economics

2.     Structuring your portfolio so that you’re playing with rather than against the market and its expected returns

3.     Understanding the “human factor,” i.e., your own behaviors, ingrained through eons of evolution and tricking you into making the worst financial decisions at all the wrong times


Today, we’ll introduce you to the first point: the evidence at play in our capital markets.  


You, the Market and the Prices You Pay

How do you achieve every investor’s dream of buying low and selling high in a crowd of resourceful and competitive players? The answer is to play with rather than against the crowd, by understanding how market pricing occurs, according to these insights:

·         Group intelligence drives efficient pricing

·         It’s not whether breaking news is good or bad, it’s whether it’s expected or unexpected

·         By the time you hear the news, the market already knows it

·         Financial “gurus” are no better than you at consistently predicting the markets


The Power of Group Intelligence in Price-Setting

Before the academic evidence showed us otherwise, it was commonly assumed that the best way to make money in what seemed like ungoverned markets was by outwitting others at forecasting future prices and trading accordingly in domestic and international stocks, bonds, commodities, real estate and more – or by hiring high-priced market analysts to do this for you. 


Unfortunately for those who are still trying to operate by this outdated strategy, academia has revealed that the market is not so ungoverned after all. Yes, it’s chaotic, messy and unpredictable when viewed up close. But it’s also subject to group intelligence, whereby groups of independent players (such as free market participants) are better at consistently arriving at accurate factual answers than even the smartest individuals in that same group.


Applying group wisdom to the market’s multitude of daily trades means that each individual trade may be spot on or wildly off from a “fair” price, but the aggregate average incorporates all known information contributed by the intelligent, the ignorant, the lucky and the lackluster.


Instead of believing that you can regularly outguess the market’s collective wisdom, you are better off concluding that the market is doing a better job than you can at forecasting prices. 


The Effect of Breaking News on Market Pricing

The next step is to understand how prices are set moving forward. What causes market prices to change? It begins with the never-ending stream of world news. Here, it’s critical to be aware of the evidence that tells us the most important thing of all: You cannot expect to consistently improve your outcomes by reacting to breaking news.


How the market adjusts its pricing is why there’s not much you can do after the news is released. First, it’s not the news itself; it’s whether we saw it coming. In other words, it’s not just news, but unexpected news that alters future pricing. By definition, the unexpected is impossible to predict, as is how dramatically (or not) the market’s group intelligence will respond to it.


The Barn Door Principle

Another reason breaking news is relatively irrelevant to your investing is what we’ll call “The Barn Door Principle.” By the time you hear the news, the market already has incorporated it into existing prices. The proverbial horses have already galloped past your open trading door. This is especially so in today’s electronic world, where price adjustments typically occur within the first few post-announcement trades.


Unless you manage to be among the very first to respond to breaking news (competing, mind you, against automated traders who often respond in fractions of milliseconds), you’re setting yourself up to buy higher or sell lower than those who already have set new prices based on the news – exactly the opposite of your goal.


Financial Gurus and Other Unicorns

As touched on above, you’re also ill-advised to seek a market-forecasting, financial guru to pinch hit for you. As Morningstar strategist Samuel Lee has described, managers who have persistently outperformed their benchmarks are “rarer than rare.”


Bottom line, if such outperforming experts did exist in reliable numbers, we should expect to see credible evidence of it. Not only is such data lacking, the body of evidence to the contrary is overwhelming. Star performers – “active managers” – often fail to survive, let alone persistently beat comparable market returns. Across the decades and around the world, a multitude of academic studies have scrutinized active manager performance and consistently found it lacking.

Next Up, Structuring Your Portfolio

So far, we’ve assessed some of the hurdles to effectively participating in efficient capital markets. In our next newsletter, we’ll address how to overcome the hurdles by structuring your portfolio to complement rather than combat the market forces at play.

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