I'm pretty smart. When it comes to investing money, intellect is dangerous. You see, everyone who invests money is smart. Trying to outsmart the smarty-pants leads to pissing contests and losing money. To convince myself away from active trading, I'm going to explain everything that I know to be true about financial markets.
Here we go.
Two sides of every trade
For a moment, we're going to ignore everything that I learned from Michael Lewis's Flash Boys novel.
Barring interference from high frequency traders in "dark pools" there are two sides to every trade. For every asset that I buy, someone is selling that same asset.
This is true of index funds (and the stocks contained therein), bonds, equities, options, currencies, MLPs, and more. If you buy it in the financial market, then someone is selling it.
Why does this matter? This leads to the conclusion that every single asset class is Alpha neutral. That means that nobody can outperform without someone underperforming. There's a foil for every hero.
This is something I didn't understand for a long time. You see in economics, we talk a lot about long run growth. Gains in productivity make everyone better off. In my mind, I superimposed this to the markets and thought investing is more than a zero sum game. And it is. The gains from underlying assets (that is businesses making money) get transferred to the owners of capital (that is investors). But beyond the gains offered by the assets, investment gains have to come at someone else's loss.
Market prices reflect knowns but not unknowns
Active investors have nearly instantaneous access to all the same information. If legislation or natural disaster or unfavorable press or scandal breaks out, the future value of an asset may change. The news will be priced into an asset within a few hours at most. That is to say, some people will sell their assets to people who are willing to buy that asset at a lower price.
So markets are fast to react to the news and any known variables.
However, buyers and sellers of assets don't consider unknowns when making their buying and selling decisions. Unknowns could be completely random, or they could be systemic risks that nobody sees. Either way, those unknown factors can't generally be baked into the price of an asset.
Why does this matter? To me it seems that in the financial markets, we can say that prices tend towards value, but they will never actually reflect value.
Market actors influence markets
In economics, we have a famous graph where supply increases as price increases, and demand falls as price increases. Where the two meet is where the price stays.
It's a beautiful picture, but that isn't how the financial markets work. Yes, each person willingly buys or sells thinking that they got the better end of the deal. But as soon as the deal is complete, the market has changed. Suddenly the perception of asset supply and asset demand has changed. The very act of engaging in the market changes the market.
You could say this is true of all markets. For example, my willingness to buy toothpaste drives up demand for toothpaste. But in reality, I think that the financial markets are particularly reactive to changes in market conditions, because of the point above. Markets reflect known variables. And trades are known variables.
Why does this matter? To me, this explains why markets can deviate far from value in some cases. By engaging in a trade, we can change the perceived risk associated with an asset thereby driving "bubble" pricing.
In Theory, practice and theory are the same...
In theory, practice and theory are the same. In practice, they aren't.
I've tried to hone a lot of theories about markets recently. If I can just do X, Y, Z, I can stabilize returns. If I just do A, B, C, I'll outperform. I can find the bottom or top of the market when D, E and F happen. (I guess three factor models aren't strong enough). Then I test my assumptions using randomized data. Guess what? My theories get trashed every time I test them.
In theory, I think that common sense and data should help me outperform based on market timing. In practice, I'm underperforming.
Why does this matter? Maybe I'm not as smart as I thought I was, or maybe I don't have what it takes to practically beat the market.
That's all that I KNOW about financial markets
You'll notice that I didn't claim that index funds are the best. You'll notice that I didn't say that it's impossible to beat the market. You'll even notice that I avoided the Efficient-market hypothesis. I've read all sides of those debates. I don't KNOW where I stand on those.
I also didn't mention any statistics. I did that on purpose too. It's way too easy to cherry-pick stats for your pet theory. This isn't about theories, this is about market truths. This is what I know. Maybe someday I'll know a little more.
I'm a wife, a mom, an employee, and a personal finance nerd who is devoted to spreadsheeting my way through life.