I’m talking about liquid. Rich enough to have your own jet. Rich enough not to waste time. Fifty, a hundred million dollars, buddy. A player. Or nothing.

Gordon Gekko (in 1987 dollars) from the movie Wall Street.

The Efficient Markets Hypothesis (EMH) is much in the news of late.  By and large it has come under attack for both being wrong and a basis for the global economic crisis from which we find ourselves slowly emerging.

There has been no shortage of attacks on the EMH.  Not least of which is the book-length treatise by Justin Fox entitled The Myth of the Rational Market. See these pieces at the Big Picture, NYTimes.com and Economist.com for more discussion of the failures of the EMH.   There are some defenders, however at the moment they are admittedly outnumbered.

Whether the EMH is true in any sense is irrelevant for investors.  Indeed the financial markets have gone along their merry way absent much interest in the EMH.  However what emerges from this debate is a fundamental truth:  It is difficult to systematically beat the markets.

Emanuel Derman at Wilmott.com (via Felix Salmon) writes:

But the EMH, if you don’t take it too literally and get carried away about axiomatically defining strong, weak and other kinds of efficiency as though you were dealing with axiomatic quantum field theory, does recognize one true thing: that it’s #$&^ing difficult or well-nigh impossible to systematically predict what’s going to happen.

Said another way there are “no free lunches” in the market.  That being said some people do “beat the market.”  How do the they do it?

Eddy Elfenbein at Crossing Wall Street notes one common critique of the EMH is that there is a whole class of investors who have beaten the stock market over the long run.  They are loosely defined as Graham and Dodders, i.e. long term value investors.  Eddy notes:

The Forbes list of billionaires contains lots of shrewd investors. I’m not aware of any that are pure technical guys. There are people who follow every conceivable strategy from astrology to Elliot Wave. Yet, time after time, it’s the value guys who rank near the top.

A logical conclusion from this is that we should all become value investors (albeit great ones) if we want to become really rich.  The ultra-wealthy are those who start (or purchase) companies and utilize the corporate structure to its maximum benefit.  Operations aside, this is done through managing the firm’s capital structure, dividend policies and maybe most importantly avoiding taxes.

Warren Buffett is of course the obvious example of “really rich”, but a good one.  While Buffett may be a superb stock picker he was able to compound that wealth through leverage and an aversion to paying taxes.  In the case of leverage, Buffett has used the insurance component of Berkshire Hathaway to take on leverage in the form of premiums paid.  In the case of taxes, Buffett “never” sells thereby avoiding capital gains taxes.  In addition his policy of not paying dividends allows for additional funds to invest and compound.

So should all the traders out there who rely on technical methods hang it up?  Not necessarily, but they do need to realize that there are some real roadblocks preventing them from becoming Warren Buffett-wealthy.  Let’s look at three of them.

The first is transactions costs.  While transaction costs have come down over time they still represent a real cost of doing business for traders.  Every trade you make involves costs: either in commissions paid, bid-ask spread or market impact.  Those costs inevitably impact returns.

The second is scale.  Every successful trader eventually faces the challenges of scaling up their trades.  Small cap traders face the prospect of having to trade large caps.  Commodities traders face the issue of position limits.  The list goes on.  This issue is especially hard on those traders managing other people’s money.  For those traders the issue hits harder, faster then for those simply trading for their own account.

The third issue is taxes.  For active traders there is simply no way of avoiding them, whether they are short term or long term capital gains or ordinary income.  There are ways to lessen the bite, but successful traders are eventually going to have to cough up a healthy part of their winnings to Uncle Sam.  This is will necessarily decrease the rate in which you can compound returns.

In short, to become really rich you are going to have to expertly own and manage your own company.  To become merely rich you may be able to trade your way there.  In either case you are going to have to develop your own method for “beating the market.”

Forbes 400 fantasies aside, for most people in the markets their aspirations are bit more modest than owning their own plane:  building a healthy nest egg, saving for college, in short a more comfortable life for ourselves and our families.

In either case the lessons are the same.  There are no shortcuts.  There are is easy road to riches.  No matter what road you choose to take you need to realize that there are potholes along the way.  The challenge is knowing how to avoid them before you blow a tire.

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