Depend on Market Efficiency – Not Pundits – to Help Protect Your Portfolio

The stock market is an amazing thing, with so many moving parts that it's impossible to predict. So don't even try to determine what it's going to do next, and don't believe people who say they can. Here's what to do instead.

By Jeffrey D. Montgomery, Investment Adviser Representative

published 31 August 2018

in Features

(Image credit: PonyWang)

Hardly a day goes by without some self-proclaimed expert making lofty, and sometimes outrageous, predictions in the media about where the markets are heading and what you should do to help protect your portfolio.

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You may have noticed their forecasts frequently include dire warnings of Armageddon in the markets. After all, that’s what makes headlines, gets them on those news shows and ultimately sells their services.

Typically, these folks work in the active management industry as analysts, portfolio managers, CEOs or some other position in which they’re paid to hunt for hot stocks and bonds. They need you to need them.

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I’m here to argue that you don’t.

I’m a proponent of evidence-based investing — and the evidence is compelling that investors are more successful when they ignore actively managed funds and invest in a diversified portfolio with an appropriate asset allocation. There’s no hype, no speculating and no gambling necessary. There are some heavy hitters whose research backs me up.

They include Dr. Eugene Fama, who won the Nobel Memorial Prize in Economic Sciences in 2013. Fama first wrote about the efficient-market hypothesis in 1965. That was decades before the Internet and a 24-hour news cycle; and yet, already it was believed that securities markets were extremely efficient in reflecting news as it spread and incorporating that information into stock prices.

Of course, information now goes public in many ways: television, social media, web news, email and, yes, old-fashioned word of mouth. But the outcome is pretty much the same: With the exact same information, some market participants will buy a particular stock, while others will decide to sell. If they come to an agreement on a price, a trade takes place.

However, that’s not all that goes into the pricing of a stock, which then translates into the pricing of the market as a whole. What about an individual’s plans and circumstances? Aunt Betty’s car blows a gasket, so she sells some stocks to pay the mechanic. Newlyweds Jack and Barb cash out their investment portfolio to help with the purchase of their first home. Bob down the street just got a huge promotion, and now he has a lot more money to invest and buy stocks. Meanwhile, Sally just turned 70½ and must start taking required minimum distributions from her IRA.

These highly personal wants and needs are all factored into stock market prices.

We also have to talk about the production and consumption of goods and services. For example, let’s say you go on vacation and forget to pack your underwear, so you run to the local chain store to buy a few pairs. You just made an unplanned transaction and, in so doing, contributed to that chain’s market value. If that underwear was made in Malaysia, you also contributed to that manufacturing sector. That simple transaction had an impact across the globe. Now multiply that by billions of transactions each day.

There are more than 7½ billion people on this planet. All with their own hopes, dreams and needs. All contributing to the global markets. All reacting to information that is readily available.

Ignore Your Gut Instincts When Investing

That’s why the market is so amazing. It is truly an efficient system that can manage all this information and effectively price it in less than a second. The billions of individual transactions going on every day on both sides of the market — buying and selling — quickly and accurately reflect the price and the current information at that exact moment in time.

Is mispricing possible? Yes, a stock could be mispriced at a single moment in time. But the market will quickly and accurately correct that mispricing — so quickly that it would be almost impossible to benefit from a mispriced stock.

How can anyone know, with some semblance of accuracy, the hearts and minds of 7½ billion people and how they will affect the day-to-day or month-to-month price of individual stocks and the market as a whole?

A simple Google search turns up hundreds of articles on the active vs. passive investing debate. Most will tell you active management fails to beat the benchmark index roughly 80% of the time. According to the SPIVA U.S. Scorecard, over the five-year period ending June 30, 2017, 82.38% of large-cap managers, 87.21% of mid-cap managers and 93.83% of small-cap managers lagged their respective benchmarks.

Which means some managers do beat their benchmarks. But here’s the problem: It’s not always the same managers year after year. So, we’re back to speculation and gambling and trying to predict the future — this time trying to predict which manager is going to outperform a particular index. What a waste of time and energy!

What should you do instead?

Believe in the markets over the long term. It’s impossible to predict the performance of an individual stock or the market as a whole. But you can trust in the efficiency of the market as prices reflect all known information.
Diversify across many asset classes. Diversification is your friend. Resist the temptation to put all or most of your money into one or two hot stocks or sectors.
Stay disciplined and rebalance. Don’t let emotions dictate your stock market moves. Keep your portfolio on track as you work toward your goals.

Remember, no one can predict the future, and listening to short-term or alarmist forecasts may not make you a successful investor over the long term. As the markets do what they do — moving up, down and sideways — stick to a plan that’s designed to help meet your personal needs.

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Kim Franke-Folstad contributed to this article.

Investing involves risk, including the potential loss of principal.

Disclaimer

This article was written by and presents the views of our contributing adviser, not the Kiplinger editorial staff. You can check adviser records with the SEC or with FINRA.

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Jeffrey D. Montgomery is the founder and president of Montgomery Financial Services LLC (www.mfswealth.com). He works primarily with pre-retirees, retirees and affluent small-business owners, helping them grow, protect and distribute their financial assets.