"SENATORS' STOCKS beat the market by 12%" blared a headline in the Financial Times. So what? Isn't beating the market what everyone tries to do? That is the main reason most people read the Financial Times in the first place. We hire stockbrokers, listen to the experts on CNNfn, watch "Wall Street Week" on PBS, and buy books that teach us how to pick stocks because we all are trying to beat the market. When choosing a mutual fund, we are looking for portfolio managers that will do better than the average. Shouldn't senators be able to hire the very best financial advisors available?
Logically speaking, the argument that experts should be able to predict which stocks will be winners or losers is profoundly seductive. It is deceptively obvious that money managers, who study the ups and downs of the market, examine the balance sheets of companies in minute detail, follow the latest innovations in products and technology, and use all the other sophisticated tools and techniques at their disposal, should be in the best position possible to forecast future stock prices. Alas, like so many other no-brainers, this one is blatantly false.
For decades, academics have known that it virtually is impossible to beat the market. This is referred to as the efficient market hypothesis, which contends that, if a person is using publicly available information only, that individual is highly unlikely to beat the market by a significant amount. Public information is anything you, your broker, or your portfolio manager normally have access to, including corporate financial statements, publications such as The Wall Street Journal and Baron's, whatever you see on TV, everything available on the Internet, all the books in the library, and whatever else is in the public domain. You might be especially lucky (or unlucky) for brief periods of time in much the same way as you might get lucky for one night at a blackjack table. Over the long haul, though, you likely will be very close to the market average.
The key to comprehending the efficient market hypothesis is understanding the difference between a great company and a great stock. Suppose your broker calls you about a great company. The firm has a strong balance sheet, brilliant management team, and a fabulous product, which is poised to take off in the next 12 months. He wants you to buy the stock. Let us suppose the broker is right on target. This undoubtedly is an outstanding company, but is it an outstanding investment opportunity? It is highly unlikely. You believe you have been given a hot stock tip. In fact, you have received very old news, relatively speaking.
As with virtually all publicly traded companies, the value of this firm's stock constantly is being analyzed and reanalyzed with high-speed computers using all available public information by hundreds of portfolio managers and analysts who are making recommendations to thousands of clients. In many cases, these "tips" are acted upon immediately, sometimes via computer trading. By the time you have heard about this company, the institutional investors and thousands of people already have bought millions of shines because they have come to the same conclusion--this is a great company. The price of the stock has been pushed up so high that it no longer is a bargain and, in some cases, perhaps no longer even reasonable. At this point, the company must earn an exceptional profit if investors are to receive merely an average return. Anything less probably would disappoint investors, causing a sell-off and the share price to tumble. This adjustment to new information does not take weeks or days, rather minutes, even seconds. In a sense, if you received the advice from your broke/, the expert, you might as well be the last person on Earth to know about this great company.
The stock market reacts to publicly released news almost instantaneously. This is market efficiency, thus the name, the efficient market hypothesis. It has been tested hundreds of times by hundreds of scientists. To date, every credible study comes to the same conclusion: The common stock market is extremely efficient, despite suggestions to the contrary made by financial service companies.
If the technical aspects are not convincing enough, think about this: If you consistently could pick the winning horses at the racetrack, wouldn't it lower the odds and reduce the pay-out if you told other people which horses to bet on? If you had a system for beating the house in Las Vegas, wouldn't you kill the goose that laid the golden egg if you wrote a book showing others how to do it? If you had a foolproof scheme of picking winning stocks, why would you share that information with me for a lousy six percent commission? Rest assured that, if I could pick stocks with that kind of accuracy, I would be on a beach in Tahiti armed only with my laptop computer and a phone, calling in orders to my broker.
Now, you might ask, "What about investors like Warren Buffet or Peter Lynch? How do you explain them?" Frankly, we don't. Maybe they know something: maybe they don't. Granted, many of the stocks they have chosen have done quite well over the years, but them are very few that have done nearly that well. Statistically speaking, them always are outliers in any random distribution. Although most will hover around the average, a few will stray well below--or above--average. This is not necessarily skill, but rather chance.
For many, the efficient market hypothesis is a depressing thought. It suggests that no matter how much research you do, how hard you work, or what system you use, your common stock returns essentially are beyond your control. You are a passenger; never the driver. For others, however, the theory is quite comforting. For one, it suggests that an investor does not need to hire high-priced money managers, or read the latest research, or constantly watch the experts on television, since he or she is likely to keep pace with the very best simply by investing at random. No matter how ignorant you are in your stock picks, you almost cannot make a mistake, at least long term.
This brings us back to the senators. If the market is so efficient, how are these guys repeatedly able to beat it by such a large amount? The answer should be obvious: The markets only are efficient with respect to public information, not confidential or private data.
Every company has secrets. Corporate executives may have secrets concerning new products under development, changes in management, or mergers and acquisitions. Some could have a substantial impact on the share price of a company's stock. However, to keep the markets fair, there are laws that make it illegal for executives and other employees to trade stock in their company based on this inside information, a practice commonly known as insider trading. Nonetheless, a study of corporate insiders suggests that they do cheat some, typically beating the market by about six percent annually.
Like corporate executives, senators also have access to valuable inside information. They are aware of likely changes in the tax laws, government contracts, research funding, trade negotiations, etc. Any of these may have profound ramifications for the various companies or industries involved. In addition, those in Congress have the power to help or hurt individual companies and industries by changing the laws. This also can impact share price.
Unlike corporate executives, congressmen can trade common stocks without restriction, buying and selling as much as they want whenever they want. They may vote on issues in which they have a personal financial interest. Furthermore, Senate members are not required to report their transactions to the Securities and Exchange Commission like corporate insiders. About one-third of senators trade common stock each year. The average "trading" senator buys and sells stock more than 10 times every 12 months. About 80% of these transactions are for less than $15,000.
In fairness, just because they have the power to earn "unfair" profits in the stock market does not necessarily mean they use it. Two-thirds of senators do not trade stocks at all and, so far, not a single member has admitted trading stocks based on confidential information he or she obtained on the job. The evidence, however, is rather compelling. In beating the market by 12% per year, the chance that they merely are lucky is very small.
Recognizing that some senators use their position to beat the market raises some interesting issues. For example, does the public care? Compared to equivalent private sector positions, the salary of a member of Congress is relatively low. Maybe "excessive" stock market profits should be viewed as a form of well-deserved, additional compensation for the work they do.
