Beating The Market? (Ep 99)
In this episode, we’re going to take a look at some academic market theories through a set of fresh eyes. Summer intern Kayla is back to share her insights into market efficiencies and help answer the ever-elusive question of whether or not you can beat the market. We delve into Eugene Fama's Efficient Market Hypothesis, contrasting real-world examples of market efficiencies and failures, from the Challenger Disaster to the Mortgage Crisis. Learn about the tug-of-war between active and passive investment strategies and gather key takeaways to optimize your portfolio.
Transcript - The following transcript was generated by a robot, so please excuse any typos or inaccuracies.
Brian Doe 0:02
It's summertime at the lake, and we are going to take a look at some old academic theories through a set of fresh eyes. Summer Intern Kayla is back, and she's going to share her insights into market efficiencies and help answer the ever elusive question of whether you can beat the markets or not you Joe, it's time to make the DOE rise. The
Walter Storholt, co-host 0:27
financial podcast with Brian doe. It's make the dough rise back again. Walter Strohl here with Brian doe, certified financial planner at living worth, wealth advisor, serving you in the lake country and beyond, based in Greensboro, Georgia. Brian's been a practicing, Certified Financial Planner Since 2013 and gonna be a great episode today, although a bit of a bittersweet one, because intern Kayla, it is her final episode with us, unless Brian can figure out a way to keep her between now and the next taping, but likely we'll have to send her back to college and back to getting smarter so she can go spread all this great knowledge that she's learned over the summer. Working with you Brian has
Brian Doe 1:06
been a delight, and consider myself lucky to have had her. Well, we'll take what we can get.
Walter Storholt, co-host 1:10
Oh, absolutely. And as we're taping today's episode, it's right before the fourth Do you guys have any exciting plans for the for the fourth weekend? Yeah,
Kayla 1:18
so my grandparents are hosting this Fourth of July party, and we invited does over so we're excited to have them.
Walter Storholt, co-host 1:24
Oh, nice. Well, you guys are gonna have a great time out there. Are you gonna get Brian out on some sort of inner tube and pull him behind a boat or, you know, try to find any ways to embarrass him out on the water or anything like that? Over the weekend?
Kayla 1:36
I hope so maybe we can take him out on the tube and go over some waves.
Brian Doe 1:40
There we go. Getting too old for that. That's awesome. Yeah, it's
Walter Storholt, co-host 1:43
got to be, got to be a little more careful. You can't just fling them around the corner like, like when you were younger there. So don't, don't break him. We were on episode, by the way, Episode 99 today, guys. So we need Brian back for Episode 100 so we can reach that milestone.
Brian Doe 1:57
Okay, we've got to come up with something good for 100
Walter Storholt, co-host 1:59
That's right, absolutely. Well, Kayla, it's been great having you on the past couple of episodes, and looking forward to all the research that you've done today and Brian's perspective on these matters as well. So yeah, it's this question, Brian that pops up pretty consistently here on the podcast, and I would imagine pretty consistently when you're working with clients, folks, maybe thinking of or currently trying to beat the market and find different ways of doing so. And as you sort of posed it, it's this perennial question, because I don't think it's one that'll ever go away, because that's attractive to try and beat the market and do better than expectations and all those kinds of
Brian Doe 2:35
things. Yeah, you always want to be the best, obviously, and you have a lot of noise out there in the marketplace. I had a email in my inbox the other day from a client about the headline that said the markets are going to be down 30% and a recession is coming. And then, on the other hand, you hear about, you know, the next hot stock, or investment superstars, and you know, at the end of the day, you're really asking, how do you consistently get the best possible returns, and be mindful of taxes, be mindful of how much risk that you're taking. And so we're going to look at some research and insights on that today and hopefully put that question to rest
Walter Storholt, co-host 3:17
Perfect. Well, I'll let you guys tell us where you want to begin and what catches your eye to start this conversation.
Kayla 3:22
So when I first arrived, Brian tasked me with looking at the difference between active and passive investing, and I was curious to know the difference and why people could think they could actually beat the market, and why there were some people who were hesitant and didn't think they could predict the future and see what stock market prices could do. And this all led back to Eugene Fama, who actually pursued a bachelor's degree in romance languages at Tufts University, interestingly enough, and what led him to finance and economics was one specific course that he took at Tufts University. And so to pursue this interest of his, he went on to the University of Chicago and got his PhD in economics. And there he studied under Merton Miller, who, at the time was researching portfolio theories and market efficiencies. So this really intrigued him, of if you could actually outperform the market. And his dissertation was titled The behavior of stock market prices. This came out in 1964 but in 1970 he put out this paper titled efficient capital markets, a review of theory and empirical work, and this is where the Efficient Market Hypothesis came to life. That
Brian Doe 4:37
sounds pretty captivating, like a captivating read, doesn't it? Walter a
Walter Storholt, co-host 4:42
little deep, little
Kayla 4:45
deep title, but the 1970s papers where the Efficient Market Hypothesis came to life, which simply states that stock market prices reflect all available information out there.
Walter Storholt, co-host 4:57
I'm picturing Kayla going back to. Knowledge, and everybody talking about, oh, you know, what'd you read over the summer? Oh, I sat on the beach and read this novel and did this.
Kayla 5:05
I read about Eugene, Fama,
Walter Storholt, co-host 5:08
efficient market hypothesis. Yeah,
Brian Doe 5:12
they'd say in the South. Bless her heart.
Kayla 5:16
I find it really interesting. But yeah, that's basically where it all started, that you can't outbeat the market. So what was
Brian Doe 5:24
significant about the paper, what, where did it end up, how did how was it received, and what impact did it have, then on the markets going forward, and how people invest?
Kayla 5:33
The impact that it had was the passive investors out there. It really brought to life passive investing, because his whole opinion was that you can't outperform or predict what stock market prices are going to do. So the best thing to do is just put your money into a passive index fund, let it grow. Don't try and let the active managers put their opinions in and try and predict what's going to happen in the future, because ultimately, the evidence shows that active managers cannot outperform the markets.
Brian Doe 6:02
And there's a lot of examples of this Walter, and you can make the case for it and against it. And I think overwhelmingly, if you have a lot of active participants in the market, if you have a free floating number that can't be manipulated for price, you can see examples of just how efficient the market is. And I also had Kayla read the wisdom of crowds. And my favorite story from that was back in 1986 when the space shuttle Challenger exploded. You know, that was a big deal. Nobody knew what happened. NASA went on to spend years and millions and millions of dollars to try and figure out what happened. And we all know that it was the O ring that exploded because they launched at too low of a temperature. But at the time, there were three major defense contractors involved in the Space Shuttle Program, Lockheed Martin, Boeing and thichol immediately, within minutes, let's say, 10 to 30 minutes of the explosion, Lockheed Martin and Boeing stock dropped two or 3% thichol dropped about four or 5% and then the market continued down through the day. And then by the end of the day, Boeing and Lockheed Martin stock price actually recovered a little bit. They were up off of their lows for the day, but thichol continued to drop to the point that they had to halt trading for the day. And so if you now look at what was that phenomenon about, thichol was the maker of the O rings, so the market, without any research, without any investigation or reconstruction of what happened, basically pinned the blame for the shuttle blowing up on thichol and the O rings. Maybe it wasn't their fault. It was the engineer's fault for launching it too cold of a temperature, but very interesting how the market acted in real time, and so the pricing within, within 30 minutes, and even by the end of the day, pretty well pinned where, where the fault was going to lie for that, for that disaster. So I just think it's a really cool story, because you have all these different people, experts, non experts, traders, analysts, people who know the business and people who are just observing collectively came up with the right answer. And so that makes a really, really strong case for how efficient, how efficient the markets are under the right circumstances. Well, the flip side of that is, how do you explain bubbles and inefficiencies and the mortgage disaster, I think, is one that is most recent and fresh on everybody's mind. And you had a situation where these very opaque securities were being created, mortgage backed securities. You had government pressure on the banks to lend to certain credit score and income groups, socioeconomic groups, because they were getting blamed for under serving certain markets. And then you had certainly Wall Street greed factored into that, because they were making big profits on these things, and you just have a little bit of the mania phenomenon. And at the end of the day, there were very inefficient markets, because you had one or two big banks actually controlling the credit ratings and the pricing on some of the these sophisticated instruments. And they were, they were being manipulated. So there's definitely cases where you could beat the market. And the great heroes of the movie, The Big Short are the guys that sluiced this out and shorted the subprime market and ended up making a ton of money on it. And everybody thought that they were crazy. But great movie wreck. Recommendation, by the way, if you're looking for one over the summer,
Walter Storholt, co-host 10:02
yeah, if Kayla, if you haven't seen that one, add that to your list. And it's not a book, you can. I mean, it is a book. And actually the book is really good too. But check out, the book
Brian Doe 10:11
is good, but the movie does an excellent job of bringing the characters to life, yeah,
Walter Storholt, co-host 10:15
very, very entertaining, too. And Star, star studded cast, so, and it's got a very high rewatch ability to it, believe it or not, a movie about finance, very easy to watch. So yeah, so you've got these two sides. Brian, so a great case for a great case against, is this just like an exception to the rule? Or are we going to have this division? Quite often,
Brian Doe 10:35
you definitely have active money managers out there. The myth lives on. The legend lives on. And you have investors like Warren Buffett, or, you know, back in the 80s, Peter Lynch was was running the fund at fidelity. And you'll you'll get managers that seem to be able to outperform or certain fund companies that tend to have a long term history of of beating the market. But when you look at the data, it's not the norm, it's the exception rather than the rule.
Kayla 11:05
So when you look at a chart of the percentage of active managers that survive and beat these benchmarks over three year periods, the percentages only range from about as low as 23% to as high as 46% so these percentage numbers aren't that high and consistent.
Brian Doe 11:23
So yeah, when you when you look at the data, as much marketing material is out there and as much advertising gets spent on on some of these funds, the evidence is just not there that the active managers outperform. And I think this shows, if you look at fund flows and the amount of dollars that are in index funds versus active management. The mutual fund world seems to have peaked as far as dollars maybe 1020 years ago. To have to go back and check the exact ad on that. And then, as we've seen that allocation shrink a little bit, you've seen a huge growth in index funds. And so then that leads us to our next problem of, how do you actually pick the right kinds of funds and keep hope alive? Maybe that you do have the ability to outperform once in a while, but not jeopardizing your portfolio to do so.
Walter Storholt, co-host 12:12
So if active management is kind of pushing up as something that's a little on the fence and got some concerns about it no better than flipping a coin. It would lead one to think, all right, what's the better way? What's the other direction? That we can maybe seek out an alternative.
Brian Doe 12:27
So the big thing is, if the evidence shows that the markets are generally efficient, except for these occasional cases of bubbles and Manias, and you're probably not going to outperform, especially when you factor in things like taxes, index funds become the way to go. Well, index funds got popular with John Bogle in the 70s. He was the Vanguard pioneer with the growth of all the index funds. And one of the flaws is most market indexes, standard, Poor's 500 the NASDAQ 100 their market cap weighted. In other words, the biggest companies get the biggest allocation to that fund. So if the market cap of Apple, Tesla, Google and Nvidia makes up 20% of the S, p5, 100 index, for example, then you're going to get a huge overweight to those few companies. So the solution to that then becomes, well, I want, I want more exposure, deeper into the index. And so some companies have equal weight indexes. So if you buy, you put $500 into the equal weight S, p5, 100 index, you're going to put $1 to every company, regardless of how large they are. And those, those can work out very well too. They just have different risk and performance characteristics. Another approach is dividend weighted. If you want to focus on high quality dividend stocks, maybe you want to avoid the volatility of the growth, they've screened out your best dividend paying stocks, and then they weight the allocation to those based on their dividend, excellent way to get some equity exposure, but also good good income at the at the same time. And then the other one that we've looked at very close this summer is dimensional funds. They take a modified approach to indexing where they they look for stocks that look like the equities that are in the index funds. Now they will still buy the stocks that are in the indexes, but if there's a overweight to one company, but they can find a similar company that has better fundamentals, better earnings, momentum, better profitability. They'll substitute that stock to give you a potentially better opportunity to have better quality and ultimately outperform. And they have a index approaches out there. They have one of the better track records over time, and. So
Kayla 15:00
going back to Eugene Fama, his groundbreaking research back in 1970s he met David booth, who he partnered up with to apply his theories to create dimensional and they worked together to put together his theories and apply them to the funds. But this ultimately led him to be a Nobel Laureate for economic sciences in 2013
Brian Doe 15:23
Yeah. So it turned out his look into efficient markets, and actually applying that to very low turnover, properly managed funds, based on deep quantitative analysis, turned out to be one of the one of the better fund companies out there. Pretty
Walter Storholt, co-host 15:39
neat to see how that relationship and everything came together and has has led to this, really, I guess, kind of change in viewing of different lenses and trying to bring a new perspective to investing and who it applies to. And I guess those are some some great additional questions. Brian is, you know, what can the average person now do to take some of this information and some of the things that Kayla dove into over the summer here and apply it to their own financial lives.
Brian Doe 16:04
Yeah, so all of these different approaches basically amount to different camps or schools of thought, and everyone that follows one of these approaches is 100% convinced that their way is right, and what we've learned from everything is you want to diversify. So you probably want some market cap weighted portfolios, because the in the past 10 years, if you didn't own those top 10 stocks, you missed out on a lot of performance. But you may also want some equal weighted the volatility of equal weighted funds is a little bit higher. That's great for accumulators. Dividend weighted may be good for retirees who want the income dimensionals approach skews a little more to the value side, and so you don't want to leave them out. And of course, you always want to have the hope that the active managers are going to outperform. So if you put a little bit of active management into your portfolios. Make sure you do that in your IRA, so that you get tax deferral, and then you could create a very small roster of individual stocks. And so Kayla and I have spent a little bit of time building out some investment sleeves, and I'll let her tell you how those come together. Yeah. So
Kayla 17:20
we've been putting together portfolio sleeves, and you know, this includes equity, ETFs, bond funds, REITs and MLPs, and we've really experimented with the percentages of allocations for each one of these. And it was really interesting to see how each one of these performs and looking at its past performance, so we can create a customized portfolio to fit their specific needs and requirements. Yeah, so
Brian Doe 17:46
it's been a great project. We've ran these through Morningstar. We've back tested them, we've looked at what it does to the risk and the volatility, and I think basically we've got Kayla all teed up for some great projects as she goes into her finance and MBA classes, my hope is she is leagues ahead of her her peers as she as she carries on with her studies, no
Walter Storholt, co-host 18:09
doubt there will be a leg up there when you return to school, Kayla, and really appreciate you taking the time and energy to research this over the summer and share some of This knowledge with us here to wrap up episode 99 in the meantime, if you have questions about diversification, about the right funds, about the right way to plan for retirement and your financial future, well, those are the kinds of questions that Brian's answering each and every day from clients and helping them craft portfolios that are built to get them to their retirement years and all the way through it. And so if that's the kind of planning that you're looking for, you're looking for, comprehensive, take no further look than reaching out to Brian and setting up a complimentary review of your portfolio if you want to take control of your financial future. And you're not exactly sure the best place to start, well, Brian has a Certified Financial Planner with more than 20 years of expertise. Can be your partner in that journey, and he meets the highest standards of training and ethics always putting your best interests first. That's the mark of a Certified Financial Planner. You can get a complimentary 15 minute call with Brian to gain some clarity about your financial goals and prepare for that more secure tomorrow. All you have to do to take advantage of that opportunity is go to livingworth.com and click book a call. Again, living worth.com and click book a call. Or you can dial 706451 9800 706451 9800 Well, Brian and Kayla, thanks you again for another great episode today, and Kayla for your time over the summer and all the help that you've provided, and for joining us here on the show and putting us with Brian and I through the last couple of months, this has been fun. Thank you. I've
Kayla 19:45
had a great time down here,
Walter Storholt, co-host 19:46
Brian. Don't break any bones at the lake. All right, I'm
Brian Doe 19:49
gonna keep it nice and safe. I'll be right on the dock enjoying the view of the fireworks. Wonderful.
Walter Storholt, co-host 19:52
Well, thanks for everybody for joining us on today's show. Hope you had a good one, and we'll talk to you next time right back here on make the dough rise. You. Music.
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