Is the stock market a rigged game?
- December 16th, 2012
The following is a post I wrote last week for Marketwatch.com. It got a fair amount of play and was at one point the most popular post on the site. For long-time readers of Abnormal Returns the themes presented will be somewhat familiar. Thanks to Jonathan Burton the Money & Investing Editor at Marketwatch.com for the opportunity.
Is the stock market today a ‘rigged game,’ too difficult for individual investors? This is a common argument used to explain the defection of the individual investor from the stock market. For example, Brian Lund at bclund writes:
The average trader sees the market increasingly as a “rigged” game, one in which they have little or no chance to win.
and Felix Salmon at Reuters in a discussion of falling trading volumes writes something very similar:
Nowadays, however, the message is sinking in: it’s a rigged game, you can’t win, and you’re better off with a passive strategy.
There’s nothing wrong with a passive investment strategy. Indeed I spend much of my book discussing how for the vast majority of investors a largely hands-off investment strategy focused on index funds is by far and away the best solution to their investing needs. However in some respect simply owning index funds outsources your portfolio to others to deal with the ‘rigged market.’
Then again one could easily argue today’s markets are not all that rigged. One need only look at the performance, or underperformance, of active mutual fund managers and hedge fund managers to see that. If the market were at all rigged one would expect to see some sign of it in this data. For now, however these professional managers are having a difficult time beating the market over any reasonable time frame.
Nor are investors necessarily fleeing the stock market en masse. Since the onset of the financial crisis persistent outflows from actively managed equity mutual funds have been more than offset by inflows into equity exchange-traded funds. Some argue that this says more about the preference of investors for index funds more so than equities.
Felix Salmon argues that what we are seeing is the decline of individual stock picking. Salmon notes how this “upper-middle class hobby” of stock picking resembles that of golf. There in fact some very good parallels between the way most investors and golfers approach these pursuits. One that springs readily to mind is the belief that a new piece of equipment (golf) or newsletter (investing) will somehow change poor underlying results. Salmon notes the high cost of online services and newsletters focused on individual investors and their generally poor performance. Readers of the Hulbert Financial Digest which tracks the performance of newsletter writers will not be surprised by this assertion. However a strict focus on performance may very well be misplaced.
In contrast with golf, which is a strictly discretionary activity, investing is very much a responsibility for adults today. As I wrote in the introduction to my book:
If investing is hard, even for professional investors what chance do individual investors have? As adults in today’s society we are largely set adrift in the investment world with little in the way of guidance or objective advice. Whether you are saving for your retirement, a child’s education or simply looking to build a better life you need to possess some basic investment skills. Some argue that investing is in a certain sense dead. Investing isn’t dead, but the odds are stacked against us all. Whatever the odds, we still need to make an effort to save and invest for our futures. [page x]
For some individuals that saving and investing comes in the form of individual stock picking. If the challenge of competing against the world’s biggest investors motivates them then so be it. The motivation to read and learn about investing is far more valuable than the potential underperformance against some benchmark like the S&P 500. There is in fact some research that indicates those investors who stick with it tend to learn from their investing experiences. That is why getting young adults to start their investing careers sooner rather than later is so important.
Even index-type investors need to continually educate themselves. Enough things change in the financial markets over time such that a entirely hands-off approach to investing is an increasingly risky bet. Even for those who rely on investment advisers to do the heavy lifting there is an educational imperative for their clients. You can’t be a thoughtful consumer of financial services without having some background in the basics of investing.
I would argue that much of the confusion over individual participation comes from a confusion over time frames. David Merkel at the Aleph Blog notes in a post about being “well-off in life” the importance of taking moderate risk, having a long time horizon and not trading too aggressively. In that type of approach, a do-it-yourself investor has a chance of achieving moderate success.
Nat Stewart at NAS Trading notes how many of the problems investors run into are a mismatch between their perceived investing time horizons which are long and their realized time horizons which are much shorter. This mismatch has a tendency to push investors to abandon sound investing strategies in search of the hot new thing. I would argue that consistently following a sub-optimal investing strategy is far preferable to flitting from hot strategy to the next.
Is the stock market a rigged game? Maybe at the very shortest of time frames. Is stock picking dead? The trends show a marked decline in interest in it. All that being said investors can’t simply turn their back on the stock market. The lost decade for stocks has for sure discouraged investors, but what is the alternative? Treasury bonds yielding 2%? Not investing at all? Neither of these are a sustainable long-term solution.
Indeed the emphasis on the long haul is important. At the very shortest of time frames individuals have little chance competing against the institutions and the high-frequency trading algorithms. However individuals with a long time horizon have a marked advantage against benchmark-focused institutions. We may not yet be in a golden age for stock picking but it is hard to argue that there has ever been a better time to be an individual investor.
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