Buying and selling assets at the correct price is important to all investors. Despite some widespread beliefs it’s easy to go wrong even in large markets. This affects all investors, as index investors want to avoid buying assets that have little chance of good returns in the future and active investors want to find opportunities to profit. Based on some recent reading I’ve started to draw conclusions about second-guessing the market that apply equally to indexers and stock pickers.

As I’ve written about earlier, the efficient market hypothesis doesn’t match what we can easily observe. I just read a post on the How to Make 7 Million in 7 Years blog, where the author disagrees with  Larry Swedroe about the reality of efficient markets. The points it brings up expand on my previous post about career risk. Some money managers may suspect that they’re not doing the best thing but go along with it so it looks like they’re doing a good job. That’s not the only reason for mispricing though.

The “efficient market” price of an asset is based not on information about the asset but on people’s assumptions and conclusions regarding that information (“prices will never go down”, “prices can keep rising 10% per year no matter where you’re starting from”). As Robert Shiller and several behavioral economists have documented, people can easily come to the wrong conclusions and these mistakes can be contagious. In this case you can look at the same information and decide that everyone else is wrong; if you’re right it’s a chance to make a profit or avoid a loss.

There’s a few common elements in many cases where the market isn’t efficient, even if you don’t know the future. Apart from a lack of understanding of risk and a belief in a new world (like the famous quote from a japanense investor in the 80s who said “we’ve moved to an entirely different way of valuing stocks”), the biggest thing linking these cases is the fact that people lose sight of what investment means.

When you invest you are simply giving up control of your money now to get more later. This comes in many forms but you always need to be paid for taking on risk and inconvenience. If an investment isn’t doing this in one way or another then it’s not really an investment. On the other side, if you’re getting paid and not taking on any risk or inconvenience then you don’t know what’s really going on. Aside from validating investments this also allows you to compare them. You can find the minimum that you should be paid to give up control of your money for a period of time with no risk. You can see increasing levels of returns as the risk rises, and decide if the added value compensates you.

Although guesses about future risk may vary (the meaning of risk often isn’t clear but I’ll have more about that later), the biggest mistake is to forget how to invest. If the whole market goes crazy and people temporarily make profits from doing the wrong thing you can join in and hope you get out on time or decide to look for investments that actually give you what you want. If you decide to participate it will be nothing more than blind speculation; that can’t be called investing.

As an index investor this principle is very useful in deciding on an asset allocation. To invest in an asset class I need to understand what I’m being paid for, how much I’m being paid, and reasonable expectations for future changes in the payments. If an asset class doesn’t meet the basic expectations for any investment then it shouldn’t be in my portfolio. I can then compare different asset classes to find the right mix; this principle might lead me to decide that I still want an asset class but my expecations of future returns are different and I need to change my allocation.

Just sticking to this basic principle should provide warnings about asset classes that are severly overvalued or undervalued and help adjust my allocation over time. If you prefer more active investment you can seek out markets where this principle isn’t being applied and try to profit from the fact that people will eventually lose interest in whatever ideas drove them away from common sense. Preferences for stocks, bonds, industries, and countries may change over time but the basic facts of investing don’t – ignore them at your own risk.

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