Stock Market for Beginners

There’s an old joke about two economists walking down Wall Street when they come upon a $100 bill lying on the ground. As one bends over to pick it up, his colleague stops him and says “Don’t bother. If that was actually a $100 bill, someone would’ve already picked it up.”

This joke epitomizes the efficient market hypothesis in a nutshell. The efficient market hypothesis (EMH) says that all known information is reflected in the price of an asset, so it is impossible to outperform the market on a longterm basis using only publicly available knowledge. If you ask most professional investors/traders, they will laugh at you if you tell them you believe in the EMH. They’ll tell you that the ones that believe it (mostly academics) are the ones that can’t make it in the real world, and the ones that don’t are too busy out there making money than trying to debunk it. Furthermore, if anybody truly could produce a counterexample, why would they share it with the world? They’d rather use that knowledge to make a boatload of money rather than render that knowledge useless by diluting it among the public.

There are countless professionals on Wall Street and elsewhere that have consistently outperformed the market - many that I’ve spoken to personally that have averaged over 20% compounded annually over 10-20 years. Sure, statistically speaking, there’s going to be a portion of the population that get lucky and outperform. If you’ve identified those individuals, however, and they continue to outperform, then it’s obvious that they know something you don’t (i.e. Warren Buffet).

My take on the EMH is that over a long time span, the market is pretty efficient. Information is traveling faster and faster these days as the internet and mobile technology has facilitated the transfer of information. With this increased knowledge, easy access to online brokers, cheaper commission, and a public emphasis on starting investing at a younger and younger age, liquidity of the markets has risen considerably over the years. The more liquidity in a market, the more knowledge is being reflected in a price, and the more difficult it becomes to outperform.

How can you beat the market then? I have identified two ways based on this logic:

1. Trade in the short term. Random fluctuations in asset prices happen in the short term while the long term is fairly efficient. (For those of you with some physics background, think quantum mechanics vs. general relativity.) Short term trading no longer is governed by fundamental analysis. Instead, we now enter the realm of technical analysis and event-driven price movements.
2. Trade in low volume markets. Low volume markets do not have the amount of knowledge that’s needed to be compressed into asset prices. You can take advantage of this by trading in developing foreign markets or by trading in relatively small and unknown assets.

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