KW: “a dangerous idea has taken hold in the financial services industry,” warns our trend follower Michael Covel. Your financial adviser may be the most dangerous person to your wealth.
“Millions all over the world like you have been told that following it is the surest path to a comfortable retirement,” he says. Just one problem: “Those who blindly follow this approach will get killed every time the market collapses.”
Maybe you’ve heard of it. It’s called “efficient market theory.” Or sometimes “efficient market hypothesis.” For our purposes today, we’ll call it EMT.
“In essence,” Michael explains, “it says that market prices fully reflect all available information. The prices you see quoted in the markets include all information there is to be known about those assets. And any new information that comes out is immediately priced in.
“The implication of this theory is that the market is rational. Inefficiencies are quickly remedied, so it’s not possible to consistently beat market returns.
“What has flowed from this widely accepted wisdom is the belief that you can’t outperform the markets… so why even try?”
As with many economic and financial fallacies, this one begins with the late Paul Samuelson, often lauded as the “father of modern economics.” If you took a college econ course, chances are you had his textbook. And to reach people who didn’t take a college econ course, he had a regular platform in Newsweek at a time people still read Newsweek. Yes I remember Economics 101, the big green Samuelson text book. Samuelson began preaching the gospel of EMT in the mid-1960s. “The academic theory Samuelson helped spread has become the cornerstone of modern finance and has transformed the financial services industry,” Michael says.
In 1976, Samuelson penned a Newsweek column that became legendary in financial circles. It sang the praises of investment funds that passively track an index like the S&P 500… and lamented that such funds were available only to big-bucks institutional investors.
Forty years later, “passive” funds are all the rage for retail investors — as opposed to “actively” managed funds that try to beat the market. “For the past 14 years,” says Michael, “active equity fund managers have underperformed all benchmarks. These incompetent managers have helped cement the academic EMT case that you really can’t beat the stock market. “That’s why we’ve seen investors flooding into passive investment funds that merely track an index, instead of actively trying to beat it. In late 2003, 12% of all U.S. open-end mutual fund and ETF assets were invested in passively index products. Today, that percentage is at 30%, and rising.”
Alas, EMT has some fatal flaws. “The most egregious one,”says Michael, “is that it assumes that investors are rational.”
Heh…
“If investors were rational and markets were efficient,” Michael points out, “we would never have had things like Dutch tulip mania of the 1600s, the South Sea Bubble of the 1700s, the Panic of 1857, the stock market crash of 1929, the stock market crash of 1987, the dot-com bubble in the late 1990s and the financial crisis of 2008–09.”
Said the legendary trend following trader David Harding, “This theory of rational markets treats economics like a physical science — like Newtonian physics — when, in fact, it is a human or social science. Human beings are prone to unpredictable behavior, to overreaction or slumbering inaction, to mania and panic.”
The folly of EMT has even given rise to an economist joke. You’ll have to excuse us if you’ve heard it before. It goes like this: Two economists are walking down the street. One says, “Hey, look, there’s a $20 bill on the sidewalk.” The other says, “That’s impossible. If it were a real $20 bill, someone would have already picked it up.”
Key point: “Passive index investing keeps you fully invested no matter what,” Michael warns. “We’ve seen two 50% drops on the S&P in the last 15 years. What’s worse is the market has historically suffered a downturn of at least 50% every 10 years or so. “Most people don’t realize that a 50% portfolio loss requires a 100% return just to get back to even. One mistake like that during your lifetime could ruin you forever… especially if you’re approaching your retirement years.”
And get this: Paul Samuelson didn’t even follow his own advice. “Back in 1969,” Michael tells us, “Samuelson was founding partner of an investment startup fund called Commodities Corp. At the start, Commodities Corp.’s traders were firm disciples of EMT when trading commodities and stocks. But they turned out to be poor performers. In its first year, the fledgling company lost $100,000.
“Then the firm adopted a technical trading system that over time morphed into what’s now known as trend following. Commodities Corp. grew from $2 million in capital at its founding in 1969 to $30 million by 1980. And in 1980, it really started taking off — generating trading profits of $42 million.”
The lesson: Using a trend following system says Michael, “it’s relatively easy to outperform the stock market with limited downside risk. Samuelson got rich by abandoning EMT. There’s no reason why you can’t too.”