We probably all have that friend who, every so often, will whisper in our ear something like “You HAVE to invest in company X – it’s the next big thing”, or “The Y sector is booming, get in on it NOW!” This friend most likely read some article on some website by some “analyst”. They are now convinced that they are the next Warren Buffett, and that you should consider yourself lucky to be their friend and appreciate these incredible insights. I hope I’m not bursting anyone’s bubble here, but you should probably take what they say with a large grain of salt. Studies have shown that even professional active asset managers don’t consistently outperform the market.
Beating the Market?
The stock market is widely considered to be “perfect” and “symmetric”. This means that all the relevant information for determining value is publicly available and no player has an unfair advantage over any other player. In other words, the price of a stock at any given moment reflects the entirety of public knowledge which is shared by all players.
There are, of course, a few caveats to this.
Statistically, some investors (professional or not) DO consistently beat the market. Whether this is due to some (presumably legal) secret methodology or sheer luck is undetermined. A hint to my opinion on the matter lies in Derren Brown’s (highly recommended) “The System”.
Creating an unfair advantage by using non-public information. This is known as “Insider Trading”, and it is illegal. For example, a CEO of a drug company buys their own company stock a few days before a public FDA announcement to approve the company’s latest drug.
The rise of algo-trading (typically high-frequency trading performed automatically by computers) has led to the use of public data in order to gain a legal advantage over human investors. This might sound like a great way to beat the market, but there are two main issues to consider. First, these companies usually don’t accept “outside money” – they trade their own funds solely for their (and sometimes their employees’) benefit. Second, and perhaps more importantly – similarly to humans, most algo-trading companies also fail to beat the market!
Trading based on industry knowledge or expertise. This is the most interesting exception, since it’s accessible to most investors and is completely legal. However, it is very risky, and the reason isn’t as straightforward as one might expect. Let’s explore.
Can Knowledge Be an Enemy?
We all have knowledge which is relatively “exclusive” to us, based on our background. For example, doctors are more likely to be up to date with the latest trends in medical breakthroughs, while aerospace engineers know what cutting-edge technologies are going to take over the drone or space industries. The “knowledge is power” aphorism has a financial impact in these cases. Having knowledge in a specific field can prove to be advantageous when it comes to trading within that field.
But there’s a fly in the ointment. A grave danger is lurking – exposure. What I mean by this is that if you have specific industry knowledge, it’s usually because this is what you do for a living. It’s quite rare (though not impossible, of course) to be extremely knowledgeable in fields which you aren’t involved in on a daily basis. How many bankers do you know who have an insightful understanding of the latest advancements in quantum computing?
Alas, as one invests in a company, sector or trend which they know very well, they are over-exposing their financial well-being to their source of income. Why is this bad? Let’s take an (extreme) example.
Greg, a corn farmer, has decided to invest in the latest agritech companies – after all, he definitely knows this space better than the average Joe. Unfortunately, a month after Greg places a hefty investment in this sector, a severe nationwide drought hits, catching many promising agritech companies off guard. The entire sector takes a nose dive.
But Greg hasn’t only lost value on his investment – his own corn crops have suffered greatly, and his produce is a fraction of its full potential. Needless to say that if Greg had invested in the nanotechnology sector instead, his overall financial outcome would have been significantly better after the drought. But what does Greg know about nanotechnology?
It’s extremely hard to beat the market. The few ways to do it are either statistically improbable, inaccessible, illegal or very risky. Always remember – knowledge can, on occasion, end up being a curse and work against you. Diversify, decorrelate your portfolio from other aspects of your life and track the market as best you can. If the world prospers, so will you.
I am CPO and Co-Founder of Cred. Cred is a disruptive WealthTech startup aimed at enabling financial advisors and institutions to truly personalize each of their retail clients' portfolios, based on their unique backgrounds, financial situations and preferences. This is the way investing will work in our generation, and we’re excited to be pioneers on this journey.
When you invest in securities, you always hold the risk of losing some or all of your money. I am not a licensed investment advisor, and the above content was written as an informative article to the general public. It should not be viewed as financial advice by me or by Cred to any specific group or individual under any circumstances. Any investment action you decide to take is solely at your discretion and at your own risk.