One of the surprising implications of the market efficiency theory (which I touched on in Part Two of this series) is that you can’t beat the market. You can beat it 50% of the time – in fact, you must beat it 50% of the time, otherwise someone could just watch what you do and do the opposite. But you cannot consistently beat the combined information of all market participants.
If this is the case, a natural corollary is that no one should have much of an unfair advantage. If the market goes up by 10%, everyone from your local pensioner to the New York hedge fund manager should be reaping the (same) rewards. Ditto if it goes down.
And yet, of course, it doesn’t feel that way. In this article, I’m going to make a big assumption – I’m going to assume that markets are efficient. Then I’m going to describe why, despite not being able to beat the market, the financial industry can continue to reap disproportionate rewards.
1. Heads I win, Tails I win: The Benefits of Being a Market Maker
Markets don’t just happen. A good market (e.g. a stock market) requires work: there must be standards for how things get bought and sold. People who trade in the market must be licensed to keep out trouble-makers. And the whole thing must have rules and regulations that level the playing field.
Even if markets are efficient, the benefit of being a market maker – a company that runs the sandbox in which everyone else buys and sells – can be tremendous. Firms like NASDAQ, brokerage Charles Schwab, and investment bank Goldman Sachs make money by facilitating companies’ and investors’ access to the stock exchange. By collecting fees to list companies on an exchange, buy or sell stock, or underwrite a public offering, these firms make money whether the market is going up or down. They don’t need to beat the market – they simply benefit from peoples’ desire to participate in it.
2. Collecting Set Rate Fees for Managing Money: Being a Money Manager
A study once found that professional money managers are no better than Las Vegas strippers when it comes to beating the market. Nonetheless, they do have one advantage when it comes to financial reward: money managers often take a share of your portfolio regardless of how your stock fares. As a result, a 1% commission on that $1,000,000 portfolio will reap annual returns of $10,000 regardless of how the market does.Given the immense pool of money that is being actively managed on Wall Street, commissions like this can go a long way towards slowly funning money out of pensions and savings and into the checking accounts of professional money managers.
3. Getting There First: High-Frequency Trading
High-speed trading is said to be immensely profitable, and I have no reason to suspect otherwise. By using very fast connections, traders can generate returns by doing the financial equivalent of trading currency between currency exchange kiosks before prices adjust – what’s called arbitrage. By getting there before anyone else, so-called high-frequency trading represents a surprisingly caviler way of trying to beat the market – and one that many European countries are currently trying to ban.
4. Buying in Bulk: the Dimensional Fund Advisors Strategy
Starting in the 1980’s, a gang of University of Chicago graduates came up with a very clever way to beat the market. Essentially, they used the fact that certain stocks for small companies are very illiquid to their advantage. The fact that there isn’t a large market for these stocks meant that companies hoping to unload many shares ran the risk of watching the price fall as it became harder and harder to attract buyers at the original market price. What DFA did was to find such sellers and purchase their shares in bulk, directly from the seller, bypassing the market. By negotiating a price that was higher than what the seller could have expected in the market but lower than the current market price, DFA found a clever way to make money from illiquidity. In the 80’s and 90’s, this approach was effective in enabling to DFA to offer some impressive returns.
5. Mine the Date: The Small / Value / Momentum Approach
In recent decades, financial economists have found that small-cap stocks and stocks with low P/E ratios tend to outperform the market without subjecting their owner to additional risk. Why? It’s not entirely clear – though it may likely be that people perceive small companies as having higher default risk (a risk that can be largely negated through diversification). Likewise, low P/E/ values are tautologically under-appreciated by the market. In both cases, the effects of investing in these firms has declined over time. However, additional data mining holds that momentum stocks – those that have gone up for 12 months straight – hold promise for above-market returns. Will this finding hold now that everyone knows about? Time will tell.
6. Lying: the Madoff Approach
It’s a truism that many people are perfectly happy to ignore how the sausage is made, so long as it makes them money. Ponzi schemes and other sui generis “financial innovations” have been around since the dawn of the stock market, and human nature suggests that they’re not going anywhere. Nonetheless, the mechanics of using short term deposits to fund short term redemptions – rather than investing those deposits for long term gains – is a perfectly effective way to earn above-market returns. Until you get caught, of course.
Bonus Answer: Being Really, Really, Good
Technically, this one doesn’t really count, because if markets are efficient, then the market contains the combined knowledge of all its participants, and not even Warrant Buffet can beat it. But, apparently, he does beat the market. Continuously. Why? Don’t look at me. However, if I had to guess, and if I was a true efficient market believer, I would say that Buffet it taking on more risk than the market. If so, his good fortune may not last forever.
There you have it. Six ways to beat an efficient market, plus a bonus. Did I miss anything? Please let me know.