The second step in Choosing your Investment Philosophy involves examining your beliefs about the market. Our beliefs, whether conscious or subconscious, are the root of action. Beliefs about the market and how it works are largely responsible for dictating decisions made regarding investments. Formed for many reasons and based on numerous factors, beliefs may be changed instantaneously based on new information or a new understanding. For this reason, it is important to consciously examine your beliefs about the market.
First, let’s examine the efficient market belief.
What does it mean? Well, the name efficient market refers to the underlying premise of this view that the market, left to its own devices is efficient. It’s based on supply and demand. The free market is the best determinant of market prices. What this means is that all knowable and predictable information about future prices and movements is already factored into the current price. Therefore, only new and unknowable information and events change prices going forward. In this context, the randomness of the market makes it impossible for any individual or entity to consistently predict market movements and capture additional returns that are unrelated to risk. Markets that are overvalued, or underpriced, are not identifiable in advance.
Is there any proof? The debate about the efficiency of markets, has resulted in hundreds of empirical studies attempting to determine whether specific markets are, in fact, efficient. Many investors are surprised to learn that a tremendous amount of evidence supports the efficient market belief. Furthermore, academic research over the past fifty years in the field of economics, strongly supports the theory that markets work.
The 1990 Nobel Prize in Economics was awarded to Harry Markowitz, Merton Miller, and William Sharpe for their role in developing the concept of Modern Portfolio Theory, or (MPT). MPT is a long-term investment strategy that includes diversification and asset allocation.
Now let’s look at the other side of the story, otherwise known as the market failure belief.
What does it mean? The basis for this belief is that the market fails to price goods and services accurately. Because there are flaws in the systems, it is possible for some individuals to identify in advance which prices are incorrect and, in effect, predict the future. Simply put, overvalued or under priced markets can be forecast and predicted. By systematically finding mispricings, either in stocks or market sectors, it is possible under this belief, to both increase returns and avoid losses in investments.
Is there any proof? Empirical evidence supporting an inefficient market is poor. Statistical studies show that professional money managers who use speculative techniques, designed to take advantage of mispricings in the market, are only able to provide higher returns than the market index, at a level with what would be expected to by blind random luck. On the other hand, it is easier to find anecdotal evidence to support this view. Individuals who have “beat the market,” are easily found on magazine covers and radio shows, TV talk shows or Internet chat rooms.
There is an allure to this method of investing that is compelling to our basic instincts as human beings.
Perhaps for the first time in your life, you know there is a choice to be made about how the market really works, and you have examined both belief systems. Many investors live in a haze of confusion, never understanding that there is an important choice to be made here. They are trapped in the Investors’ Dilemma, trying to rationalize beliefs on both sides of the continuum. While this may be comfortable and uncontested by media and advertisers anxious to sell products, it only leads to chaos for the investor.
If you want to escape the Investors’ Dilemma, it is crucial that you take a stand regarding your market belief. This is where the rubber meets the road for the investor. In order to develop your own Personal Investment Philosophy, you will need to choose between the belief systems of market efficiency or market failure.
Do you believe, as Adam Smith did, that free markets set prices better than any individual or group of people can? Or, do you believe that markets fail, and that there is an individual or group of individuals who best know what prices should be?
What do you believe? What makes most sense to you?
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