Sunday, May 11, 2008

Rational Agents, Inefficient Market

I was thinking hard about Efficient Market Theory. Yeah, right, that widely criticized EMT. For a log time (about last 6 years) I thought that main problem of that theory is "rational agents". The very basis of the theory. The idea that all (or most) of stock market participants act rationally. That was especially hard to believe after internet bubble. But now I have second thoughts.

Two pieces of information changed my opinion.

1. New amateur traders survive at average only 7 months before burning through money.
It tells me that market is at least efficient to weed out least rational agent. I assume that people without experience on the market have least rational expectations.

2. Jim Cramer's book "Mad Money, Watch TV, Get Rich". The phrase from it "Big mutual funds and big hedge funds are The Market" (or something similar, sorry, I'm to lazy to scroll through the book).

So, to sum it up: Big mutual funds and big hedge funds make the market, because of their sheer size. And market, as any more or less free market, efficiently sets prices based on trades those big "agents" do. Those big companies employ very good people, most of them are in business for decades, we just can't assume that they don't act rationally. At the same time we saw a lot of irrationality on the market. What's wrong?

It's plain economics 101: Those big institutions act rationally in their best interest. We might assume that it would be to make maximum profit from portfolios at reasonable risk level. Wrong! Mutual funds get most of their profits from fees. They rationally don't (and, from economical point of view, shouldn't) care about performance, at least until investors start leaving in droves. But in most cases, unless fund is really run into the ground, investors can't leave. Now how it works: I, as most of you, have a 401k plan at work. Do I have much choice in what funds that fund is invested? No, no way. My company, as many big companies, made a deal with an investment bank, which offers a "choice" of about 15 mutual funds. Most of which are plain crap, and couple I chose just barely beating indexes. Now, all decisions from all "agents" are rational: my company made rational decision to work with this bank, bank made rational decision to offer very limited number of funds and I made rational decision to invest in 401k because I'm getting about 80% income from this money right away, in form of employer's match. I calculated that I need more than a dozen years to beat this performance with my (not bad) 17% return for the last 10 years.

So, really, EMT is killed by, well, government. Because it makes it profitable to me to invest into crappy funds instead of investing in stocks of companies I really want to buy.

I could rant here in real libertarian fashion for real free markets, except for the fact that such animals never existed in nature. Let's think instead what can be done about it on the level of individual investor.

There is only one answer: take more risk! Because big institutional investors are risk averse, because they don't care about performance (or not much), we can beat them by taking more risk than they do. We need to find good companies when they are young, when big guys don't see them or just don't think they are big enough for them (like Intuitive Surgical couple of years ago). We need to invest in great companies which are not loved by big guys for different reasons, like Google (it doesn't follow unwritten Wall Street rules) or Apple (Wall Street doesn't like companies taking big risks). We have to avoid stalwarts at all cost, unless they consistently pay good dividends and increase them at every opportunity.

There are, probably, other ways to beat big guys at their game. But that's what was working for me for the last 10 years.

Full disclosure: at the time of publication author had long positions in Intuitive Surgical, Google and Apple.

Disclaimer: This article is not intended as an investment advice. Every person should make her/his own investment decisions based on all available information and advice from her/his own financial advisor.

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