When thinking about saving for college or retirement, “bookie” and “point spread” are probably not the first words that enter an investor’s mind. Nevertheless, there is an important parallel between sports betting and investing that has powerful implications -- the sports betting market and the stock market are both fairly efficient. In other words, whether you’re analyzing Vegas point spreads or Wall Street stock prices, it’s very difficult (if not impossible) to uncover inaccuracies and do it fast enough to exploit those anomalies.
For example, a study in the Journal of Economic Literature that covered six NBA seasons found that the difference between the pre-game point spread, ultimately determined by amateur betters (i.e. “the market”), and the average game’s actual point spread differed by less than a quarter of a point.1 How could a disorganized group of competing, amateur betters arrive at such accurate predictions?
In his book The Wisdom of Crowds, James Surowiecki demonstrates that the answer lies in the very nature of what a market is -- a diverse, independent, and decentralized group of decision makers, where, in this case, the point spread or the stock price is their aggregate decision. More times than not, when the self-interested, competing, and irrational decisions of individuals are aggregated in a marketplace, their collective decision will be more accurate than the individual market “experts.” That’s why between 1984 and 1999, the Wilshire 5000 Index (the broadest U.S. market index) outperformed nearly 90 percent of mutual-fund managers.2
When it comes to making decisions, the collective knowledge of all market participants is far greater than the knowledge of any single expert and as a result, the market as a whole finds better solutions to problems (like the allocation of capital). Financial markets incorporate new information so rapidly it becomes very difficult to profit from an informational advantage. In the fixed income market, for example, the window for profiting from the release of new information lasts about 40 seconds.3 Following a positive report on CNBC, a stock’s price can rise within 15 seconds, making it virtually impossible to exploit the information before the stock price is impacted.4
The total collective knowledge of investors includes expected future events. In other words, if you’re pessimistic about future market returns and want to sell your equity, chances are good that you’re not alone in your pessimistic outlook, and that pessimism has already been incorporated into stock prices. Essentially, it’s already too late to sell.
If you’re bearish about a certain stock, that’s not enough. That’s analogous to being bearish about the Dolphins beating the Patriots last year -- it’s a no-brainer. What’s key is whether you are more or less bearish than the point spread. If you bet on the Patriots, they have to beat the Dolphins by more than the point spread for you to make money. Same goes for the financial market. It’s been the case that IBM’s stock rose 13 percent after IBM’s earnings fell 20 percent. Why? Because the market had already priced IBM stock according to the expectation that earnings were going to fall more than they ended up falling. In another case, Cascade Communications earnings rose more than 100 percent, while the stock price fell over 30 percent.5 To make money on Cascade, you had to bet against Cascade despite their soaring earnings.
The Cascade example alone shows that stock prices are not 100 percent or even 90 percent accurate. They are, however, accurate enough to make it extremely difficult to exploit mispricings on a consistent basis. Individual investors may be best served by acting on the assumption that the market is perfectly efficient and stock prices are 100 percent accurate.
In an efficient market, if an investor systematically takes on more risk than the market, the investor should be compensated with a higher return than the market over long periods of time. Historically, that has occurred: A dollar invested in 1926 in a large-cap index would have grown to an estimated $3,077 by 2005. That same dollar invested in an inherently riskier small-cap index would have grown to an estimated $15,922. If that were not the case, why would anyone take the extra risk of smallcap investing? Likewise, by taking on less risk than the market, an investor’s return would be expected to underperform the market over a long period of time (think Treasury bills).
The bottom line is that market efficiency is a good thing. It means risk and return are related. It means there can be a systematic approaching to investing. Namely, by effectively managing portfolio risk, an investor can effectively manage portfolio returns.
1 Sauer, “The Economics of Wagering Markets,” Journal of Economic Literature, 36, p. 2021-2064.
2 Surowiecki, The Wisdom of Crowds, p. 33.
3 Journal of Applied Economics, Spring 1996.
4 Journal of Financial Economics, Spring 2002
5 Fortune, March 17, 1997.
