Posted by on Jan 12, 2010 in Articles & Advice, Blog, Columns, Featured |

Image Credit: Heath Hinegardner

By Jason Zweig |  Jan. 9, 2010 12:01 a.m. ET

Can’t anyone here play this game?

With the market so erratic at pricing stocks, it is tempting to think you can do better.

Between the Dow Jones Industrial Average’s record in October 2007 and the bear-market low in March 2009, Bank of America‘s stock fell 94%. Then, by year-end 2009, it went up 380%. It wasn’t just financial stocks that acted like yo-yos: Over the same period, Alcoa‘s stock fell 87%, then more than tripled.

How can such crazy swings in price be “efficient”? As millions of smart buyers and sellers compete to maximize their wealth, they update stock prices with all the relevant information that’s available. That’s what an “efficient market” means. It presumes that the market price is the best estimate of a stock’s intrinsic value, or what all its current and future cash flows are worth.

But the fact that the market price is the best available estimate doesn’t mean that the market price is right.

In 1974, the great financial analyst Benjamin Graham wryly described the efficient-market hypothesis as a theory that “could have great practical importance if it coincided with reality.” Mr. Graham marveled at how Avon Products, which traded at $140 a share in 1973, had sunk below $20 in 1974: “I deny emphatically that because the market has all the information it needs to establish a correct price the prices it actually registers are in fact correct.”

Mr. Graham proposed that the price of every stock consists of two elements. One, “investment value,” measures the worth of all the cash a company will generate now and in the future. The other, the “speculative element,” is driven by sentiment and emotion: hope and greed and thrill-seeking in bull markets, fear and regret and revulsion in bear markets.

The market is quite efficient at processing the information that determines investment value. But predicting the shifting emotions of tens of millions of people is no easy task. So the speculative element in pricing is prone to huge and rapid swings that can swamp investment value.

Thus, it’s important not to draw the wrong conclusions from the market’s inefficiency. “The evidence does suggest that the market is not rational,” says Meir Statman, a finance professor at Santa Clara University in California. “But watch out for the voice of the devil inside of you saying that therefore it must be easy to beat the market.”

For one thing, hindsight blinds you to the truth. Last March, in the bowels of global financial panic, it was far from clear that Bank of America would survive and that the stock was dirt cheap.

The market had priced such companies as if they might go out of business because plenty of information suggested that was a possibility, and because fear was then so pervasive that optimism felt almost like a form of irrationality.

So, while it may seem obvious today that Bank of America is a survivor, most investors didn’t think the market price for the stock was too cheap last March. As Prof. Statman puts it: “The market may be crazy, but that doesn’t make you a psychiatrist.”

Looking back at how cheap stocks got last spring, you may conclude that any idiot should have known to be buying them hand over fist. But mutual-fund investors sold out of stocks all year long; in March alone, at the very moment when stocks were cheapest, fund investors dumped $25 billion worth.

Furthermore, money managers chase whatever’s hot and shun whatever’s not. Those who are the best at this game attract more money in rising markets and lose fewer clients in falling markets, pushing prices further away from Mr. Graham’s “investment value.” These are the last people who will go against the grain to buy cheap stocks at the bottom.

In the short run, at least, the herd behavior of the pros makes it even harder for you to take a winning bet against the “speculative element” in a stock’s price. It takes superhuman courage to buy into a hurricane of selling.

Finally, even money managers who can beat the market may leave clients lagging behind the market. Consider a fund manager who outperforms the averages by 2.5 percentage points annually, before expenses; that’s a spectacular return. But his trading costs and management fees are likely to eat up at least 2.5 percentage points, leaving his clients no better off than if they had bought an index fund that simply mimics the returns of the overall market.

That’s why, even after the crazy swings of the past decade, index funds still make the most sense for most investors. The market may be inefficient, but it remains close to invincible.

Source: The Wall Street Journal