EPTEfficient Market Hypothesis
This is an interesting/controversial idea from academic finance that says, according to wiki, "financial markets are "informationally efficient". That is, one cannot consistently achieve returns in excess of average market returns on a risk-adjusted basis, given the information publicly available at the time the investment is made."
Let me rephrase that in a way that matters to you and me. I have no idea what the heck any company is worth. Neither do you. And here's the kicker -- it doesn't even matter. This is an extremely powerful line of thinking that you should always keep in mind when investing.
For today, we'll use the example of Bank of America (symbol = BAC) as our example to illustrate my points. It should be pretty familiar with anyone in the US, but any large company would make a good example. So let me ask you what Bank of America is worth right now?
- If you're so inclined, you could make a completely random guess, say, $100 billion. It'd be a pretty good answer.
- If you knew some basic finance analysis, you could look at how much money they make, how much money it costs to run the company, guess how much they'll make next year and the year after that, figure out the interest rate, use your nice little discounted cash flow valuation formula and tell me an answer. Not bad.
- If you were meticulous, you'd take into consideration changes in government regulations, the state of the economy, how their competitors are faring, what the CEO's plans for the company are, changes in interest rates, etc. Even better.
- Now if you were a professional, you'd assign some probabilities to every one of those things and maybe even come up with a probability distribution of the value of BAC over the next month or year. That would be pretty baller.
Here's another approach. BAC is worth whatever people are willing to pay for it. (At the time of this writing, around $118 billion.) The stock is trading around $11.66-$11.67 at the close.
But wait, couldn't that price be completely wrong? If you're so sure it's higher, go buy some stock. I'll sell it to you for $11.67. If you're so sure it's lower, sell some stock. I'll buy it from you for $11.66. Now all I have to do is find one sucker who thinks it's higher and one sucker who's lower and I just made $0.01 by being the middleman. Without knowing a single thing about the company or what it's worth!
Okay, so I made a penny... what's the big deal? Well, on average, BAC trades 260 million shares a day. In case you didn't do the math, that's $1.3 million a day, or roughly $300 million a year. Of course, I'm making it sound a whole lot easier than it really is, but that's the basic idea. This guy who knows absolutely nothing about what the company is worth is making millions buying one cent lower and selling one cent higher. All of this with very little risk.
To belabor the point with another example, let's say you're 100% sure that the price of BAC should be $15. You've done a month of research on it in every way possible, and now you're ready to bet your life savings on it. Heck, you've borrowed money from all your friends and family and all their friends and family.
You've raised $5 million to bet that BAC is going up. Now, that's so much money that everyone who's selling it to you must be out of their minds right? You're ready to pay up to $15 for a share of BAC, and they're selling it to you for $11.67?! Your bet is so large that it should at least drive up the price of BAC right?
In reality, $5 million is probably going to move the price of BAC by one whole cent. You know why? Because there's someone out there willing to bet $5 million that BAC is worth less than $11.68. And what makes you think the guys out there betting against you don't have a team of professional analysts studying a company for 3 months and $10 billion of money to work with? People call this capitalism. Free markets. Supply and demand.
Think about that for a moment. How are you ever 100% sure about whether a stock is going to go up or down. Every time you buy stock, somebody has to be on the other side selling it to you. How are you 100% sure that you're right and they're wrong? What makes you think you're smarter than the guy on the other side? Until you can present a compelling argument on why you're better at pricing companies than the rest of the world, there's little reason to think you're right.
How does that apply to people like you and me who aren't professional analysts? It basically means that we really have no insights into whether BAC is above or below it's current price. Investing in individual companies is more or less a coin flip.
Being right is usually luck, not skill. Don't get me wrong, there are professionals out there who have a lot of skill at picking stocks, but there are also a lot of them who are really lucky. The real question is how to tell apart skill from luck?
