Ever heard of a thing called PMT? Yep, it’s an idea known as Perfect Markets Theory, among other monikers — and it’s bonkers.
It says that whatever your investing strategy or knowledge, you can’t beat the market — because you can not possibly know anything that the rest of the market learns at exactly the same time.
But hang on there. For this ridiculous idea to be true, we’d have to accept that just before the peak of the dotcom bubble and just before it collapsed, no individual one of us could have beaten the market wipeout by getting out (or, far better, by not getting caught up in the first place).
Are these people serious?
It’s all about the idea of the so-called rational actor, which assumes that every individual and every organisation will always act rationally in response to everything that is known. As far as that goes, I’d agree — the number who act irrationally is surely tiny, but it’s all conveniently obscured by the actual meaning of rationality.
All it means to act rationally is to act because one has a reason to do so. That really is all, and anything beyond that is usually just meaningless academic puffery. There is nothing whatsoever in the theory that suggests that any two actors will ever act for the same reason.
I want to buy shares in Over the Rainbow (LSE: OZ) today because I think they’ll soar tomorrow? That’s rational, but it doesn’t mean I’m right. But surely, you might think, avoiding such individual urges won’t help you beat the institutional investing companies, because they don’t fall for such emotional urges.
I say you’d be partly right, but you would have missed their Achilles’ heel.
The majority of investment managers do not have their customers’ returns as their primary objectives. Their clear interest lies in maximising their own profits, which depends on attracting and retaining clients (who pay handsome charges), and that’s done via their marketing departments.
I remember reading one of the sadly-missed Terry Pratchett’s Discworld novels in which a civilisation was inherently too honest to have such a discipline as marketing — and when they were finally convinced by outsiders that it was a good idea, they were so honest that that they called the profession “liars”.
Investing firms are in business to make the fattest profits they can for their owners, however much it costs their customers (and as an aside, that’s why I’m a big champion of investment trusts as pooled investment vehicles, because customers and owners are one and the same). So their horizon is rarely 10 or 20 years ahead, but usually as short as the end of the next financial year — or even as misleading as the next quarter.
That’s why we see such a thing as ‘window dressing’, in which some investment firms buy the latest hot stocks just before their reporting deadlines in order to look good, when their long-term performance really is not so impressive.
The way to beat the market is easy. All you have to do is align your personal interest with long-term profit over 10 or 20 years or more — and you’ll immediately have the advantage.
I hope to bring you some more thoughts on beating the market in the coming weeks.