How Markets Really Work

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How Markets Really Work. Created: March 2005. Following is a newspaper column-length article (typically 750 words or fewer), originally authored by Larry ...

How Markets Really Work Created: March 2005

Following is a newspaper column-length article (typically 750 words or fewer), originally authored by Larry Swedroe and appearing in the St. Louis Post-Dispatch. Using analogies to sport wagering, it discusses why it is so hard for investors to consistently profit from trying to pick winning stocks.

There are interesting analogies between sports wagering and the stock market. In many sporting events, it is easy to identify the better team. Therefore, while even a novice sports fan might be able to predict 60% of the winners, a knowledgeable fan might forecast 75% correctly. However, fans could selectively limit their betting to games where the outcome appears highly certain (a great team is playing a poor one). In this scenario, a knowledgeable fan might correctly forecast 90% of the games. This logic can also apply when investing in equities — it is not necessary to buy every stock, instead buy only the stocks of great companies. Despite being able to select the games on which to bet, it is difficult to consistently win. I have never met anyone who became rich betting on sports. Two reasons there aren’t more stories about rich gamblers are the point spread (the amount by which the favored team must win) and the cost of betting. While many people believe that the point spread is determined by bookies, market forces actually determine the spread. Bookies only set the initial spread (they set prices to balance supply and demand since they don’t want to make any personal bets). Studies on horse racing, basketball

How Markets Really Work March 2005

Copyright © 2005, BAM Advisor Services LLC

and football show that “markets” are highly efficient — it is extremely difficult to beat the odds or the spread on a consistent basis, especially after costs. Bookies (like stockbrokers) collect commissions, for example requiring you to bet $11 to win $10. Stock prices are set in a manner similar to how point spreads are established. In an initial public offering (IPO), the lead underwriter surveys potential investors to determine the price. After the IPO, the forces of supply and demand take over and what is known as the price-to-earnings (P/E) ratio acts like the point spread. Consider the following: •

Company A is a glamour growth stock earning $1 per share.



Company B is a distressed value stock earning $1 per share.

At what price would the shares of these companies sell? Company A might sell at 30 (P/E of 30) while Company B might sell for 7 (P/E of 7). The P/E acts like a point spread — just as bettors would give away more points to bet on a great team, investors have to pay much higher P/Es for great companies. Great sports teams have to overcome large point spreads for gamblers to win bets. Similarly, great companies have to overcome high P/Es to produce above market returns. In gambling, the middlemen are the bookies; in investing, they are stockbrokers. In each case, they win as long as individuals play.

Lessons Learned It is not enough to identify a great team or a great company. The risk and reward “playing field” is made even via the point spread that gamblers have to overcome, or the high stock price that investors have to pay. In addition, they each have to pay to play. While it is possible to win when betting on sporting events/stocks, the consistent winners are likely to be the bookies/brokers. This makes accepting market returns (through passive investing) the prudent strategy.

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By investing with a passive approach, investors can earn the market rate of return in a low cost and tax efficient manner. And they will likely outperform the vast majority of investors. The bottom line is that while gamblers make bets (speculate on individual stocks and actively managed funds), prudent investors let the markets work for them. So, the next time you consider buying the stock of what you believe to be a great company, remember that what you are doing just may be the equivalent of believing that you can bet on a great team without giving away any points.

This material is derived from sources believed to be reliable, but its accuracy and the opinions based thereon are not guaranteed. The content of this publication is for general information only and is not intended to serve as specific financial, accounting or tax advice. To be distributed only by a Registered Investment Advisor firm. Copyright © BAM Advisor Services LLC, 2005.

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