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The Only Investment Tip You Will Ever Need

April 17, 2013

Learn the Efficient Market Hypothesis. Be able to coherently explain it to anyone who asks you what it is. Once you acquire this skill, you will never again need advice from anyone ranging from some skeezy internet site peddling a get rich quick scheme, or a slick suited investment banker making millions a year. It doesn’t even matter if you believe only the “weak form” of the argument or the strong form. Maybe there is someone out there who can pick stocks and make a profit, but you are not that someone, you will never be that someone, and you will never meet that someone.

More importantly, even if you did meet that someone, the fees they will charge you for their services will far outstrip the additional return you will get. Any investment broker who charges high fees is effectively a con artist. I don’t blame them for selling mutual funds which skim 20% off the top every year. I blame the fools who actually give them money. The worst part is, the con artists flat out let their marks know about the con. Don’t fall for it!

The Logic
Start with an stock that is worth $100. Let’s say someone has information that the stock will be worth more in the future. They would respond by buying the stock and holding it, and then selling it after the price had gone up. But the act of buying the stock itself drives up its price through the forces of supply and demand. A rational trader would continue to buy the stock until the price had reached what they thought the price would be in the future, so until the current price is $105. If the trader is correct, they will profit from the difference between what they bought the stock for and what they sold the stock for.

Notice what happens for everyone else: They are able to see the price of the stock quickly increase from $100 to $105. Once the stock is at the new higher price, there are no more profit opportunities to be made. Only the first person who trades based on the information is able to make a profit. Everyone who acts tomorrow based on the $105 price will make 0 profit. It is only by adding new information to a market price that you make excess profits. This is why publicly available information doesn’t help amateur traders (or anyone but HFT traders really). It is incorporated into market prices far too quickly for a human being to respond.

Another way to look at it is by the law of averages. If you invest in an index fund, you get the average market return, guaranteed. The average investor also gets the average return, then subtracts their fees. In order to get an above average return, you need to be an above average trader, and so far above average that your returns are higher than the average trader by more than your fees. Remember by average, we’re not talking about average person, but average dollar of capital. Someone running a $5 billion dollar hedge fund is weighted a lot more heavily toward the average than someone managing their own 401(k). Furthermore, you have to also have to weight everyone who mimics an investor. When Warren Buffet makes a trade, he brings a whole raft of imitators along with him. Even if you believe excess returns are caused by skill and not luck (luck seems more plausible to me), skill is quickly dissipated in a liquid market.

What to Do
Focus on diversification and low fees. Make sure you know what the mutual fund is buying. “Proprietary trading” seems to me a code word for “scam”. If the broker can’t tell you what the fund owns, assume it is a pyramid scheme. No amount of “prestige” or “elite status” saved Bernie Madoff’s victims, or for that matter Lehman customers. Don’t dump all your money into one stock or bond, or for that matter one commodity. You might make a lot, but you could easily be wiped out too.

Further reading:
Hedge Funds underperform other investment types. More here.
Actively managed funds have lotterly-like odds to beat an index fund.

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