Most professional fund managers, paid to beat the market full time, fail to beat a plain index fund over the long run. So how would you know if your portfolio did?
Learning objectives. After this week you can (1) state the efficient market hypothesis and its three forms; (2) measure your return against the market; and (3) recognize bubbles and three common behavioral biases.
Remember this: good news is usually in the price before you can act on it.
1) The efficient market hypothesis (EMH)
The EMH says stock prices already reflect available information, so finding mispriced stocks is very hard. It comes in three forms:
- Weak form: prices reflect all past prices and volume, so studying charts (technical analysis) can't reliably beat the market.
- Semi-strong form: prices reflect all public information, so reading the news and the financials can't reliably beat it either.
- Strong form: prices reflect all information, even private, so not even insiders could earn excess returns.
2) Beating the market, measured
Millions of investors chase every piece of news, so it is usually priced in within moments. That is why most active managers trail a broad index over time, and why a low-cost, diversified index fund (one that simply holds the whole market) is a strong default. Your yardstick here is SPY, an ETF that tracks the S&P 500, 500 large U.S. companies.
Return vs. Market = Your Return % − SPY's Return % (same days)
If your portfolio is up 3.1% and SPY rose 2.4% over the same days, you beat the market by 0.7 points. If you are down 1.2% while SPY fell 2.0%, you lost money but still beat it by 0.8.
3) Bubbles, crashes and biases
A bubble is prices rising far above fundamental value on excitement; a crash is a rapid, severe drop, often when a bubble bursts. A smaller fall of about 10% is a correction. Three biases push investors the wrong way:
- Herding: buying because everyone else is, instead of on your own analysis.
- Overconfidence: overrating your own skill, which leads to trading too much.
- Loss aversion: feeling a loss more than an equal gain, so you hold losers too long.
Quick self-check
(a) Under semi-strong efficiency, can reading public news reliably beat the market? (b) You returned +1.5% while SPY returned +2.5%. Return vs. market? (Answers: no, that news is already in the price; 1.5 − 2.5 = −1.0 point.)
Common mistakes
- Calling a gain a win. Up 2% in a week SPY rose 4% is trailing the market.
- Comparing different days. Your return and SPY's must cover the same stretch.
- Reading one good week as skill. Luck looks exactly like skill over a few weeks.
This week in the arena
Find SPY's closing price on the first trading day of Week 1 (Yahoo Finance's historical prices), and its price today from your Extrapoli quote. Compute SPY's return over the season and put it next to the Total return in your Account panel. Then look back at your last few trades and ask whether any of them was a crowd move.