In investing, it doesn’t necessarily pay to be rational.
A rational person proportions his beliefs and actions to the evidence. Only if the evidence is strong do we act decisively upon it.
In investing, however, this might not work because strong evidence can be a reason not to do something.
Imagine you had overwhelming evidence that a share was underpriced. Would you buy it? You’d have to be quick to do so. The same strong evidence that convinces you that a share is cheap should also convince other people. And if they buy before you do, they’ll have bid up the price and so eliminated its mispricing.
This is no mere thought experiment. It really does happen: strong evidence for mispricing leads to the elimination of that mispricing.
For example, until recently we had overwhelming evidence from almost all history and almost all national stock markets in favour of the rule 'buy on Halloween: sell on May Day'. But buying on Halloween has failed on two of the last three occasions and selling on May Day has failed in the last two years. This is consistent with the possibility that investors realised the weight of evidence in favour of that rule a few years ago and so eliminated the mispricing. (It’s not, however, conclusive proof they have done so.)
Small stocks offer another example. By the 1980s there was good evidence that these had outperformed larger shares for years around the world. A swathe of funds were launched to exploit this fact. And from the late 1980s to late 1990s, small-caps then underperformed the FTSE 100. In 1999, Elroy Dimson and Paul Marsh, two economists at the London Business School pointed this out. After they did so, small caps recovered.
Yet more evidence comes from a recent paper by John Cotter and Niall McGeever at University College Dublin. They show that several UK stock market anomalies have weakened since the 1990s, such as the tendency for companies with high accruals to underperform or for growth stocks to do so. This is consistent with a finding in the US market by Jeffrey Pontiff at Boston College and David McLean at Georgetown University. They show that after academics have published evidence that particular types of shares have been underpriced in the past, such mispricings subsequently disappear.
All this is depressing. It tells us that if you wait for strong evidence of an investment opportunity you’ll miss your chance because others will already have wised up. In this sense, it doesn’t pay to be rational.
This is because, in finance, beliefs change reality. If a sufficient number of investors believe an asset is underpriced, they’ll buy it and so remove the mispricing.
All this helps explain why there is so little persistence in fund managers’ performance. If you beat the market by acting on strong evidence your advantage will disappear as others wise up to that evidence and copy you: we could call this the Arsene Wenger effect. Alternatively, if you act on weak evidence and get lucky your performance will deteriorate when your luck runs out*.
Which poses the question: given this, how can we beat the market without using inside information?
There’s a wise and an unwise way.
The unwise way is to rely on weak evidence and hunches. These will work sometimes, but not reliably so.
The wise way is to look for blockages in the transmission from evidence to prices.
One of these is the fact that many investors cannot short-sell, either because they are forbidden to do so or because it is risky. Sadly, however, if it’s risky for others then it is risky for us, too, so this won’t often be much practical use.
Another way is to look for mispricings in less sophisticated markets. Heiko Jacobs and Sebastian Muller, two German economists, have shown that the tendency for mispricings to disappear after academic researchers have discovered them is largely confined to the US. In other markets, they show, such anomalies do persist.
A more promising candidate is risk. Even if there’s strong evidence that some shares are underpriced some investors might avoid them because they believe them to be too risky.
The strongest candidates here are defensive stocks. Some fund managers have been loath to buy these because there’s a danger they will underperform a strongly rising market and so cause the manager to underperform his peers and benchmarks, thereby costing him his job or bonus. Those of us who don’t need to worry about this risk can, however, take it on.
Except for this case, all this is, I suspect, an argument for tracker funds. Holding these saves us from the dilemma of how rational we should be: should we act only on strong evidence and risk missing out because that evidence is now fully discounted in prices, or should we act on weak evidence which is irrational but might be profitable?
Many investors of course do the latter unintentionally. Which perhaps merely vindicates the author of the Book of Ecclesiastes: “The race is not to the swift, nor the battle to the strong, neither yet bread to the wise, nor yet riches to men of understanding.”
*Warren Buffett is not a counter-example to this. Economists at AQR Capital Management show that his performance has come from using his insurance company to borrow cheaply and from buying quality defensive companies of a sort that conventional fund managers have avoided because of their benchmark risk.