{"id":4918,"date":"2015-09-11T19:01:46","date_gmt":"2015-09-11T19:01:46","guid":{"rendered":"http:\/\/www.rationalargumentator.com\/index\/?p=4918"},"modified":"2015-09-11T19:01:46","modified_gmt":"2015-09-11T19:01:46","slug":"3-stock-market-tips","status":"publish","type":"post","link":"https:\/\/www.rationalargumentator.com\/index\/blog\/2015\/09\/3-stock-market-tips\/","title":{"rendered":"3 Stock-Market Tips from an Economist – Article by Robert P. Murphy"},"content":{"rendered":"
\n
\"The<\/div>\n<\/div>\n
Robert P. Murphy
\n<\/big><\/big><\/strong><\/span><\/div>\n
September 11, 2015
\n<\/big><\/span><\/div>\n
******************************<\/div>\n
\n

Recent volatility has Americans talking about the stock market \u2014 and getting a lot of things wrong in the process. Let\u2019s discuss some general principles to help clear things up.<\/p>\n

(Let me say up front that I\u00a0<\/span>won\u2019t\u00a0<\/span><\/em>be disclosing which stocks are going to go up next month. Even if I knew, it would ruin my advantage to tell everybody.)<\/p>\n

1. Money doesn\u2019t go \u201cinto\u201d or \u201cout of\u201d the stock market in the way most people think.<\/strong><\/p>\n

On NPR\u2019s\u00a0<\/span>Marketplace<\/em>, after the recent big selloff, host Kai Ryssdal said, \u201cThat money has to go somewhere, right?\u201d<\/p>\n

This language is misleading. Let me illustrate with a simple example.<\/p>\n

Suppose there are 100 people who each own 1,000 shares of ABC stock. Currently, ABC has a share price of $5. Thus, the community collectively owns $500,000 worth of ABC stock. Further, suppose that each person has $200 in a checking account at the local bank. Thus, the community owns $20,000 worth of checking account balances at the bank.<\/p>\n

Now, Alice decides she wants to increase her holdings of cash and reduce her holdings of ABC stock. So she sells a single share to Bob, who buys it for $4. There is no other market action.<\/p>\n

In this scenario, when the share price drops from $5 to $4, the community suddenly owns only $400,000 worth of ABC stock. And yet, there is no flow of $100,000 someplace else \u2014 certainly not into the local bank. It still has exactly $20,000 in various checking accounts. All that happened is Alice\u2019s account went up by $4 while Bob\u2019s went down by $4.<\/p>\n

2. Simple strategies can\u2019t be guaranteed to make money.<\/strong><\/p>\n

Suppose your brother-in-law says: \u201cI\u2019ve got a great stock tip! I found this company, Acme, that makes fireworks. Let\u2019s wait until the end of June, and then load up on as many shares as we can. Once the company reports its sales for July, we\u2019ll make a fortune because of the holiday numbers.\u201d<\/p>\n

Clearly, your brother-in-law would be speaking foolishness. Just about everybody knows that fireworks companies do a lot of business around July 4, and so the price of Acme stock in late June would already reflect that obvious information.<\/p>\n

More generally, the different versions of the\u00a0<\/span>efficient market hypothesis<\/a>\u00a0(EMH) claim \u2014 with varying degrees of strength \u2014 that an investor can\u2019t \u201cbeat the market\u201d without access to private information. The reason is that any\u00a0<\/span>publicly <\/em>available information is already incorporated into the current stock price.<\/p>\n

Not all economists agree with the EMH, especially the stronger versions of it. If two investors have different theories of how the economy works, then to them, the same \u201cinformation\u201d regarding Federal Reserve intentions may imply different forecasts, leading one to feel bullish while the other is bearish. Yet, even this discussion shows that it can\u2019t be\u00a0<\/span>obvious\u00a0<\/span><\/em>that a stock price will move in a certain direction. If it were, then the first traders to notice the mispricing would pounce, arbitraging the discrepancy into oblivion.<\/p>\n

3. An investor\u2019s \u201ctrack record\u201d can be misleading because of risk and luck.<\/strong><\/p>\n

Suppose hedge fund\u00a0<\/span>A<\/em>\u00a0<\/span>earns 10 percent three years in a row, while hedge fund\u00a0<\/span>B<\/em>earns only 4 percent those same three years in a row. Can we conclude that fundA<\/em>\u2019s management is more competent?<\/p>\n

No, not unless we get more information. It could be that fund\u00a0<\/span>A<\/em>\u00a0<\/span>is highly leveraged (meaning that it borrowed money and used it to buy assets), while fund\u00a0<\/span>B<\/em>\u00a0<\/span>invests only the owners\u2019 equity. Even if\u00a0<\/span>A<\/em>\u00a0<\/span>and\u00a0<\/span>B<\/em>\u00a0<\/span>have the same portfolios,\u00a0<\/span>A<\/em>\u00a0<\/span>will outperform so long as the portfolio has a positive return.<\/p>\n

However, in this scenario, fund\u00a0<\/span>A<\/em>\u00a0<\/span>has taken on more risk. If the assets in the portfolio happen to go\u00a0<\/span>down\u00a0<\/span><\/em>in market value, then fund\u00a0<\/span>A<\/em>\u00a0<\/span>loses a bigger proportion of its capital than fund\u00a0<\/span>B<\/em>.<\/p>\n

More generally, a fund manager could have a great year simply because of (what we consider to be) dumb luck. For example, suppose there are 500 different fund managers, and each picks a single stock from the S&P 500 to exclude from their portfolio; they own appropriately weighted amounts of the remaining 499 stocks. Further, suppose that each manager picks his pariah company by throwing a dart at the stock listing taped to his conference room wall.<\/p>\n

If the dart throws are random over the possible stocks, then we expect one manager to exclude the worst-performing stock, another to exclude the second worst-performing stock, and so on. In any event, we can be very confident that of the 500 fund managers, at least many dozens of them will beat the S&P 500 with their own truncated version of it, and the same number will underperform it.<\/p>\n

Would we conclude that the managers with excess returns were more skilled at analyzing companies, or had better money-management protocols in place at their firms? Of course not. In this example, they just got lucky. What relevance our hypothetical scenario has for the real world of investments is not as clear, but the tale at least demonstrates that past performance alone does not necessarily indicate skill or predict future performance.<\/p>\n

Studying economics won\u2019t show you how to become rich, but it\u00a0<\/span>will\u00a0<\/span><\/em>spare you from making a fool of yourself at the next cocktail party.<\/p>\n

Robert P. Murphy has a PhD in economics from NYU. He is the author of The Politically Incorrect Guide to Capitalism<\/em>, The Politically Incorrect Guide to The Great Depression and the New Deal<\/em>, and \u00a0<\/span>Choice: Cooperation, Enterprise, and Human Action<\/em><\/a>\u00a0<\/span>(Independent Institute, 2015).
\n<\/strong><\/p>\n

This article was originally published by The Foundation for Economic Education <\/a>and may be freely distributed, subject to a Creative Commons Attribution 4.0 International License<\/a>, which requires that credit be given to the author.<\/strong><\/p>\n<\/div>\n","protected":false},"excerpt":{"rendered":"

Robert P. Murphy September 11, 2015 ****************************** Recent volatility has Americans talking about the stock market \u2014 and getting a lot of things wrong in the process. Let\u2019s discuss some general principles to help clear things up. (Let me say up front that I\u00a0won\u2019t\u00a0be disclosing which stocks are going to go up next month. Even if I knew, it would ruin my advantage to tell everybody.) 1. Money doesn\u2019t go \u201cinto\u201d or \u201cout of\u201d the stock market in the way…<\/p>\n

Read More Read More<\/span><\/a><\/p>\n","protected":false},"author":1,"featured_media":0,"comment_status":"open","ping_status":"open","sticky":false,"template":"","format":"standard","meta":{"footnotes":""},"categories":[7],"tags":[4303,18,4302,335,4301,2660,497,1753,3282,1993,4300,4304],"class_list":["post-4918","post","type-post","status-publish","format-standard","hentry","category-economics","tag-arbitrage","tag-economy","tag-efficient-market-hypothesis","tag-finance","tag-money-management","tag-prediction","tag-price","tag-robert-murphy","tag-robert-p-murphy","tag-stock-market","tag-stocks","tag-volatility"],"_links":{"self":[{"href":"https:\/\/www.rationalargumentator.com\/index\/wp-json\/wp\/v2\/posts\/4918","targetHints":{"allow":["GET"]}}],"collection":[{"href":"https:\/\/www.rationalargumentator.com\/index\/wp-json\/wp\/v2\/posts"}],"about":[{"href":"https:\/\/www.rationalargumentator.com\/index\/wp-json\/wp\/v2\/types\/post"}],"author":[{"embeddable":true,"href":"https:\/\/www.rationalargumentator.com\/index\/wp-json\/wp\/v2\/users\/1"}],"replies":[{"embeddable":true,"href":"https:\/\/www.rationalargumentator.com\/index\/wp-json\/wp\/v2\/comments?post=4918"}],"version-history":[{"count":1,"href":"https:\/\/www.rationalargumentator.com\/index\/wp-json\/wp\/v2\/posts\/4918\/revisions"}],"predecessor-version":[{"id":4919,"href":"https:\/\/www.rationalargumentator.com\/index\/wp-json\/wp\/v2\/posts\/4918\/revisions\/4919"}],"wp:attachment":[{"href":"https:\/\/www.rationalargumentator.com\/index\/wp-json\/wp\/v2\/media?parent=4918"}],"wp:term":[{"taxonomy":"category","embeddable":true,"href":"https:\/\/www.rationalargumentator.com\/index\/wp-json\/wp\/v2\/categories?post=4918"},{"taxonomy":"post_tag","embeddable":true,"href":"https:\/\/www.rationalargumentator.com\/index\/wp-json\/wp\/v2\/tags?post=4918"}],"curies":[{"name":"wp","href":"https:\/\/api.w.org\/{rel}","templated":true}]}}