We have covered a cross-section of important theories about how the markets work, and we have reviewed some strategies that some investors use with a disregard for theories. Before we move on, I would be remiss if I did not explicitly state some of my biases that influence my thinking on investment best practices. If you disagree with these fundamental ideas, then you will be suspect of much that is to follow. You likely have already determined much of this on your own, but I still feel that due diligence is required.
An important takeaway from all of this theoretical talk is that fundamental analysis makes sense and it is intellectually satisfying. While predicting future income streams is a bit mystical for some, at least there is an effort to set objective criteria and value companies based on those rational factors. Unfortunately, fundamental analysis doesn’t always work because at times markets are not efficient and market participants are not rational. Fundamental analysis dominates the thinking of the “respectable” people and firms Wall Street, but that is not the only playbook in town. Fundamental analysis likely works over time, but the timeframes are unknowable, and that makes them essentially uninvestable for the average investor.
It is my belief that markets have a capacity for rationality in pricing, and they tend to revert toward rationality over time. The essential problem for the retail investor is that there is no way to determine when Mr. Market will go off the medications, and there is no way to know how long the irrational episode will last. Fundamental traders that shorted companies that they were convinced were overvalued by the market have lost billions. They lost those bets because they believed that the fundamentals should hold sway, and the prices should come into line with rational valuations. The right combination of true believers and greater fool traders can keep stock prices in the stratosphere for years.
The converse is also true. Some truly fine companies have terrible P/E ratios through no fault of their own. They just do not appeal to the Wall Street fashion show at present. The fundamental analyst needs anxiety medications when he compares the P/E ratio of Apple (18) with Netflix (225). Both are fine technology companies with bright futures. The odds are good that if you invest in Apple, you will see handsome rewards at some point in the future. You just do not know when or when the next wave of irrationality will strike. If you decide that you can’t resist the allure of the market, makes bets on individual stocks in your mad money account. My advice is to avoid such risks with your retirement account by never taking on single stock risk.
I also believe that the markets have inefficiencies at times, but those instances are increasingly rare and cannot be found by the retail investor often enough to warrant an investment decision made on the premise. If you have thought of something that will move a stock, enough investors have also thought of it to make the idea worthless. If there is a secret to getting that mythical free lunch and you know it, be sure to keep it to yourself and exploit it as much as you can as fast as you can (if it is legal). It is the nature of market inefficiencies to correct as soon as investors start taking advantage of it. This is the reason that no “get rich quick” scheme that you find on the internet can possibly be true. As soon as the lucky genius shares the idea, it ceases to work.
There are in fact several factors in the literature that can help investors achieve alpha (earnings greater than the market return) if those investors define beta (market return) in terms of the overall market as measured by the S&P 500. Simply put, you can earn more than the stock market average in profits over time, but you have to take on more risk to do it. This would not make sense if there were not a way to manage that risk.
Modern Portfolio Theory (MPT) and its progeny have provided us with these methods. The idea, then, is to create a portfolio that outperforms the market, but with no additional risk in the portfolio. It may seem counterintuitive, but portfolio risk is something completely different from the risks inherent in the individual components of a portfolio. For those who are most risk-averse, it is entirely possible to create a portfolio that will earn the same returns as the market but has much less risk. Risk and reward are intimately related, and they optimally meet in a strange statistical space known as the efficient frontier.
References and Further Reading
Kahneman, D. (2013). Thinking, Fast and Slow. Farrar, Straus, and Giroux.
Kuepper, J. (2017). Basics of Technical Analysis. Investopedia.
Sincere, M. (2010). All about Market Indicators. McGraw-Hill Education.