Graph with stacks of coins

The Efficient Market: A Hypothesis

The western capitalist societies place an inordinate amount of confidence in the abstract concept of “the market”. We commonly rely on the market to solve our problems, to ensure that our world progresses in the right direction, and to distribute the collective wealth we have created. However, many people fail to understand what a functioning market entails, and the requirements that must be fulfilled for a market to be considered efficient.

The previous article in our Introduction to Investing-series looked at the company, and how they form the basis of what we refer to as “the market”, and how, when looking at it through the lens of investing in the stock market, any given market is made up of a selection of public companies. In this article, we will investigate the economic theory of efficient markets as it relates to the stock markets where we are considering placing our hard earned money.

The Characteristics of An Efficient Market

When we talk about a market being efficient, we are referring to collective of every participating investor’s ability to price companies in a way that accurately reflect the value of said company. Now, you might argue that one person’s idea of what a company is worth can vary wildly from what the next person thinks, and you would be right. In fact, the very idea of an efficient market is that the collective valuation, the sum of all those individual investor’s varying opinions, is the right value. The market aggregate negates the irrationality of the individual investor.

Or, stated as Eugene Fama, the Nobel Prize-winning economist, did when he formulated the hypothesis of an efficient market in 1970: The price of an asset fully reflects all available information of said asset. In other words, Fama states that the market, which is a composite of every participating investor, will digest every single piece of information about a stock, and adjust their valuation accordingly. Information in this case in not just limited to financial reporting such as earnings and similar, but changes to the competitive and regulative landscapes, even all rumours which may affect the company.

Image of dollar bills
In an efficient market all information is reflected by a company’s stock price.

The stone cold implication of an efficient market is that there is absolutely no reliable way to generate returns more than market growth. This because every piece of information available is, at any given time, reflected by the price of stock. As such, there is no point in trying to predict whether the price of an asset will rise or fall in the future because it is entirely random.

If this sounds familiar, it is because most personal finance bloggers out there espouse the teachings of the efficient market hypothesis. In particular, a direct result of an efficient market is that because of the transaction costs incurred by active portfolio management, placing your money in an index fund is likely to yield superior returns. A recent report has given weight to this claim.

Financial Markets Are Not Efficient

Think about the necessary requirements for a market to be truly efficient. All information would have to be absorbed and acted upon immediately because any lag in adjusting the price according to new information is a market inefficiency. Further, human beings are not rational, even in the aggregate. Studies within the field of behavioural finance have shown that masses overreact to fear in downturns, and become overconfident in good times.

In addition to lag times and irrational decision makers, other issues such as insider trading make efficient markets a theoretical construct, more than a financial law. However, the underlying theories continue to stand strong after 50 years in the limelight, and it is worth having the ideal of an efficient market in the back of our heads as we make our investment decisions. If you want to read a more detailed discussion about the subject, a good place to start is Burton Malkiel’s research paper The Efficient Market Hypothesis and Its Critics. It was published in 2003, but a global recession followed by a near unprecedented bull market later, its discussion points still stand.

How To Invest In A Non-Efficient Market

Having established that the financial markets in which we invest are not efficient, it stands to reason that it is possible to generate returns in excess of what the market as a whole provides. How do we account for this, and can we easily construct our investment portfolios in a way that allows us to capture the excess returns?

The short answer is no. Even in a market with inefficiency, it’s hard to create extra returns. Yes, it is possible to make calculated bets and create excess returns by winning these bets. However, even in a market that is a not perfectly efficient, the return is correlated with risk, and you only “win” or create extra profits by making a bet which is more of a sure thing that the market price indicates. Otherwise, you have flipped a coin and won, which isn’t a sustainable long-term strategy.

Further, even if someone could pick winners more reliably than the market, there is simply no incentive for them to share this information with the public. Think about it, if you knew of a sure thing that other people did not, why would you share this information with the world? You would simply be telling the market to account for your knowledge and thus reducing the size of your jackpot. You can turn on the TV every single day and find people telling you that everyone else is a fraud, but they are the real deal, so you should listen to them and, more importantly, pay them for their secrets. These people don’t know. They have a more or less informed opinion, but if they knew a sure thing, they would not be sharing it with the world or even their employers. Instead, they would put all the money they could accumulate on their sure thing, and collect the proceeds.

A sustainable strategy in an almost efficient market, which is theoretically sound and with a proven track record, is long-term value investing. This strategy can be executed either by investing in broad market index funds or by creating a diversified portfolio. Whether you aim to beat the market or not, you will likely be able to generate significant returns over the long term by adopting a long-term value investing strategy.

The next editions of this article series will look at the principles of portfolio management and detail why index funds are an alternative to doing it yourself. Be sure you don’t miss out by subscribing to our mailing list. You can also follow us on Twitter or Facebook, where we shout out whenever we publish a new post.

Title photo by Ken Teegardin

Financial District San Francisco

Understanding The Company

Investing in the stock market usually entails making a bet regarding a company. But what is a company, anyways? Says Wikipedia: “A company, abbreviated co., is a legal entity made up of an association of people, be they natural, legal, or a mixture of both, for carrying on a commercial or industrial enterprise.

This article is the second in a series intended to serve as an introduction to investing in the stock market. If you missed the first article, be sure to go back and read it before proceeding. There, we established that the company is the foundation for all investing in stocks. Here, we will look at what constitutes a company, how one might differ from the next, and what investing in a company means.

As per the Wikipedia-definition in the opening paragraph, a company is simply a legal entity, comprising people gathered with the intent of doing business. And, as established in the first part of this series on getting started with investing, everybody in the western world has a relation of one kind or another to the concept. What two people think instantly think about when hearing the word company, however, will vary wildly. While one person might instinctively mention Apple, the world’s most valuable enterprise, another could very well use their favoured local, laundromat.

While it might seem that these two entities have little in common, the fundamentals of a company still apply to both. Both aim to conduct business and rely on turning a profit over a certain time span to justify its existence. And, likewise, both Apple and the local laundromat is ultimately controlled by its shareholders, all of which want to see a return on the investments they have made in the respective companies. To better understand the likeness and differences between companies, it is important to know the common distinctions made between companies.

Different Types of Companies

This list is not an exhaustive investigation of all known classifications of companies, but rather a primer on some of the most familiar terms and classifications of companies you are likely to come across as you get started with investing.

Big Corporations and Small Companies

The first and most noticeable difference between the two entities in our example is scale. One is the world’s most valuable company, as measured by market capitalisation, employs tens of thousands of people and sees daily sales in the billions. The other is perhaps a business with a single location, employing a handful of individuals, with daily sales in the low thousands.

Startups and Lifestyle Businesses

Not all small companies are created equally. One company employing five people can be radically different regarding scope and ambitions from the next. Small businesses positioned for rapid growth and world domination, typically leveraging technology to add value, are often referred to as “Startups”. Conversely, small and medium businesses without ambitions of global domination are characterised as “Lifestyle Businesses.” The name is derived from the fact that founders and owners, frequently one and the same, start these businesses to generate a living and sustain a particular lifestyle.

While media attention surrounding small businesses focuses primarily on startups, lifestyle businesses are not only profitable companies for thousands of founders and investors, but they are also pivotal providers of work for millions of people in America alone. So be careful not to dismiss the viability and importance of running, investing in, or working for a lifestyle business, even if it might seem less glamorous than the fast-paced life at a startup, or lack the corporate shine of a global megacorporation.

Public and Private Companies

An important distinction between companies, especially as it relates to investing, is that some companies are private, while others are public. A public company is listed on a stock exchange, and anyone with the required capital to purchase a single share of stock can become an investor in a public company. Commonly, shareholders of public companies receive voting rights based on the percentage of issued shares held. If you own 10% of the shares, you control 10% of the votes and thus have a significant say in the composition of the company board.

Conversely, a private company is not listed on an exchange, and, broadly speaking, not a viable investment opportunity for the general populace. Investing in privately held companies is quite a different ball game compared to publicly listed businesses and requires additional skills and know-how.

In other words, when someone refers to investing in “the market” or similar terms, that person is always talking about the universe of publicly listed companies. Remember that adage from legendary investor Warren Buffet, on how you should only invest in what you understand? Well, that goes double and triple for private companies, so make sure you investigate and thoroughly familiarise yourselves with the risks involved before you invest in private companies.

Blue Chips and Penny Stocks

If you were thinking that you were going to play it safe by only investing in public companies, it is good to be aware that not all publicly listed companies are equal. When someone asks you to picture a publicly traded company, you will most likely be imagining a Blue Chip stock. These are the mastodons of the corporate world, nationally or even internationally recognised brands, financially sound and often considered too big to fail. You know better than making a false assumption like that, of course, but generally speaking, Blue Chips are the safest investments when it comes to individual stocks.

On the other end of the spectrum are what is commonly referred to as Penny Stocks. Strictly speaking, Penny Stocks are all companies trading for less than $5 per share, but colloquially they are considered the opposites of Blue Chips. Penny Stocks are often listed on lesser known exchanges, suffer from low volume and liquidity, and are considered severely more risky than their opposites.

Making Money From Investing

As an investor, we commonly make money or see our investments grow, through one of two different ways, both of which we will look at a bit more closely here. Let us start with the most obvious way, which is that company value increases. The result is that the value of your share of the company increases as well, and it is now worth more than you originally paid to acquire it. You have made a profit!

Unfortunately, there is a caveat. Yes, your investment is now worth more than you paid for it, but you no more money in your pocket than you did yesterday before the value of your investment rose. This situation is called sitting on unrealised gains, and it highlights the importance of a stock’s liquidity, which is a measure for how often the shares of a stock is bought and sold. High liquidity stocks, which investors buy and sell frequently, are naturally easier to convert into cold hard cash than those which see lower trading volumes.

Another aspect which affects your true returns when realising your gains is transaction costs. Buying and selling are transactions which incur costs and returns realised through selling shares will be reduced by the cost of the sale. If your volume is large enough, these costs will be negligible, but underestimating the effects of transaction costs on long-term returns is a frequent mistake among investors.

The other way of earning money through investing in stocks is by receiving dividends. Distributing dividends is a way for the management of a company to return money to their shareholders, and it comes in the form of a direct payout. Think of dividends as the stock market equivalent of receiving interest on your bank deposits, and dividends are commonly measured, just like interest, as a percentage of your equity in the company.

Underestimating the effects of transaction costs on long-term returns is a frequent mistake among investors.

While some believe dividend-focused investing is a more efficient way of creating returns for yourself, others will claim alternative strategies to be more effective. With the reasonable assumption of some degree of market efficiency and a long-term investment horizon, sticking to your strategy is more important than which strategy you choose. Incurring transaction costs by making redundant sales and purchases will damage your long-term returns.

How To Pick Stock Market Winners

The million, billion and even trillion dollar question when it comes to investing is how do we pick the winners? How do we identify the companies that will perform best in the long run, and thus secure significant returns and minimise losses?

Unless you have a crystal ball or know someone with one who would be willing to give you some pointers, the boring truth is that it is impossible to know. Making this realisation, however, is the first step towards generating stable, long-term returns from your investments.

It also helps to understand the true nature investing. Circling back to the example at the very beginning of this article, the differences between the giant conglomerate that is a Fortune 500 company and your local laundromat are, at the end of the day, nuances. The one thing that is more important than anything else applies universally to every company out there, and that is that a company is just a collection of people doing business. So, no matter which company you invest in, you are making a bet that this company is run by, and employs the best and brightest people. By investing, you make the bet that the individuals who comprise the company you invest in have what it takes to outperform the competition, and generate superior returns per dollar spent.

By investing, you make the bet that the individuals who comprise the company you invest in have what it takes to outperform the competition.

Understanding this can be a daunting experience. How can you possibly gain enough insight into the people in so many companies, across so many industries, that you can ever feel comfortable assuming the risk investing entails? Fortunately, there is a way to invest which effectively eliminates the risk associated with owning individual shares, while still rewarding us with the upsides of providing capital to an expanding economy. The concept of diversification is an essential part of a well-constructed investment strategy, and it is one of several concepts we will explore in the upcoming instalments of this series, which will centre around modern portfolio theory.

Make sure you don’t miss that, or any other posts from Abovare by subscribing to our mailing list to receive an email notification when we publish a new post. You can also follow us on Facebook or Twitter, and receive updates and tidbits of information.

Title photo by gags9999.

The Royal Exchange Manchester - Last day of trading

An Introduction to Investing in the Stock Market

The best and most feasible way of increasing your financial freedom is by putting your money to work on your behalf, and putting money in the stock market is a core component of a well-constructed investment portfolio. Everyone who has read our primer on improving your personal finances, The Basic Principles of Personal Finance, are well aware. However, if we look at the number of people who invest in the market, it is clear that there are far too many individuals who are still cautious, and don’t realise what they are missing out on by not investing in the market.

Too Many People Are Not Investing

A report by Gallup from April of 2016 showed that the percentage of Americans who own stocks was at a record low, with just 52% stating that they invest in stocks. This number has more or less been shrinking since 2007 when it peaked at 65%, which means that an increasing part of the American population has been missing out on significant returns over that period. We can illustrate this by plotting the development of the percentage of Americans invested in the stock market against the growth of the US market, as represented by the S&P 500:

Chart Americans Invested vs S&P 500 2007 - 2016
Percentage of Americans with investments in the stock market versus development of the S&P 500 from 2007 to 2016. Data sources: Gallup and Yahoo! Finance.

Sure, those that got out throughout 2007 and 2008 escaped a significant value drop. But they also missed out on a fantastic growth period in the years that followed. In fact, had they held firm through the dip of 2007-2009 and until 2016, they would have seen their money double, despite the significant decline at the start of the period. If we look at the number of young people who invest in the market, the numbers are even worse. A Bankrate Money Pulse survey from July of 2016 uncovered that less than a third of millennials (ages 18-35) have investments in the stock market.

The poll also asked the subjects on why they stayed on the outside of the financial markets, and 34% of all millennials picked “don’t know about stocks” as their reason for not investing. Knowing that time in the market matters, and that getting in early increases your chances of seeing significant returns, these numbers are worrying. It is clear that a large part of the population doesn’t know enough about investing in stocks, and as a result are too scared to invest. The reasoning is sound because as Warren Buffet once advised, you should only invest in what you understand. The problem is not having a basic understanding of the financial markets, and that is what I want to address with the series of articles, of which this post is the first. My hope is that anyone who takes the time to read through these articles will finish feeling comfortable enough with their knowledge of stocks and the market to start investing.

What Is Investing, Anyways?

In this first article, we will start at the very beginning, and look at what means to invest in the stock market. To understand that, we need to start with the fundamentals. Every single adult in the western world has an intuitive understanding of the concept of a company, so we will use that as our starting point. Everyone doing business are, with few exceptions, representing a company. The place you buy your coffee? That’s a company, and if you are part of the majority that company is Starbucks. Your local barber shop? That’s also a company, but probably not one that is as big as Starbucks.

Every company has a unique vision, mission and goals, but in a capitalistic society, all of them aspire to make money. The why will differ from company to company, but all of them need to make money or inevitably face insolvency, and in turn, bankruptcy.

Pencil pointing at the word investing
What does investing in stocks mean, anyways? Photo by CafeCredit (Flickr).

If a company succeeds and makes money, who is it that ultimately profits from the good fortunes of the company? Employees may have performance related compensation agreements, but those rarely form the entirety of a company’s profits. No, the real benefactors of a company’s success are the owners of the company. They are the ones who ultimately control the company by setting the strategy, hiring and firing the management, and deciding how to handle the company’s assets. If the company earns a profit, the owners can choose to reward themselves by returning money to themselves in the form of dividends, or they can keep the money in the company with the aim of generating even higher yields.

In addition to dividends, owners of a company can also make money from selling the company, either their entire holding or parts of what they own. If someone is willing to buy it for more than they first paid for the part they own, they will have made a return on their investment.

Where Can You Buy A Company?

Imagine a big mall where you can go shopping. However, instead of shopping for clothes and gadgets, it is different companies that are on display and available for you to purchase. That big mall is an actual thing, and it is called a stock exchange! A stock exchange is simply a marketplace where you can buy and sell shares of stock of the listed companies. Examples of stock exchanges are NYSE (New York Stock Exchange) and NASDAQ.

When someone refers to “the market” or some other variation of the term, they are in reality referring to all the different companies listed on all the various stock exchanges, either in a geographic area such as the US (the US market) or the entire world (the global market). If you start looking, you will find that not every company you know of is listed on an exchange. We differentiate between listed and unlisted companies by referring to them as public and private companies, respectively. The next article in the series will look at why some companies are private, and some are public, but for now knowing the distinction will suffice.

In years gone by, buying a share company stock could be a bit of hassle. You had to have a broker, with whom you placed your order over the phone. After that, it was waiting, hoping that your bid got accepted before your broker came back to you with the verdict. These days, anyone can buy easily through online brokerages, which means that the bar for getting started with investing in stocks is no higher than opening up another bank account.

The More You Know, The Better You Can Invest

When you break it down, the general principle of the stock market isn’t very complicated. As long as you understand what I have laid out in this article, you have a basic understanding of what the stock market is. You know that there are, at the most basic level, two ways to make money from investing in shares of stock of a particular company, and that is either by receiving dividends distributed to shareholders or by selling at a higher price than you bought.

There are, naturally, layers upon layers of complexity that form together to determine how the markets function. No single person can claim to have an all-encompassing knowledge of every aspect of it, but as a starting point, just knowing the basics will serve just fine. The next post of this series looks at the company. How is a company born, which factors determine whether or not it is successful, and how does it evolve from being an operation out of your parents garage to the most valuable business in the world.

An understanding of such fundamentals will help you make more informed investing decisions. To make sure that you never miss a post from Abovare, be sure to sign up for our mailing list. Alternatively, you can follow us on Twitter or Facebook, or subscribe to our RSS feed.