Time to Stop Playing Games with the Stock Market

Year: 2021

Introduction

The recent meteoric rise in the value of GameStop stock – and its subsequent, equally precipitous crash – has understandably drawn a lot of public attention towards stocks and led to many people becoming interested in how to invest in the stock market.

As an economist, my advice for such people would be to go ahead and invest in the stock market, but to invest in it as a whole through index trackers (more on this later), rather than through professional actively-managed investment funds – and definitely not by trying to take advantage of market bubbles.

Why the Stock Market Rises

In the long-run, you can expect stock market prices to rise. A core reason for this is productivity growth. Technological progress means that firms are able to produce – and sell – more output even when using the same quantity of machinery and labour. This translates to greater revenue, some of which goes to wages for workers, and some of which becomes profits for the firm itself. Since the fundamental value of a stock is just the expected stream of future dividends paid out of a company’s profits, the price of stocks can be expected to rise.

From the 1980s to the post-Global Financial Crisis era, global productivity has grown at an average of 1.8 percent per annum. This fact – combined with inflation and population growth, which also drive up profits and hence a firm’s expected stream of future dividends – means that we can expect the stock market to grow steadily in the long-run, even if there are momentary ups-and-downs in between.

And indeed, stock market indexes (i.e. indexes that measure the price of stock markets) have gone up over time – see the Standard & Poor’s 500 (S&P 500) below, which measures the stock performance of the 500 largest publicly-listed companies in the United States.

Figure 1: Standard & Poor’s 500, 1971-2021 (Source: Trading Economics)

Historically, the S&P 500 has grown around by around 10% per annum, and after accounting for inflation, that yields real annual returns of around 7%. This makes index funds – which are a portfolio of stocks designed to reflect the composition and performance of stock market indexes like the S&P 500 – an excellent investment, one that will get you strong long-run returns.

Why Active Funds Fail

So while we can see that the stock market as a whole rises in the long-run, it is true, of course, that certain stocks will rise faster than average – and it is tantalizing to think that you could pick out those stocks and get greater-than-average returns faster. However, you should resist such a temptation.

Stocks reflect public information about a firm and its future profitability. To the extent there is a mispricing, market investors have an incentive to pile in and take advantage of it. If the stock is underpriced relative to its expected stream of future dividends, investors will rapidly buy it, causing the stock price to rise until it matches its expected value. On the other hand, if the stock is overpriced relative to its expected stream of future dividends, investors will quickly sell it, causing the stock price fall until it matches its expected value.

Overall, because stock prices will swiftly adjust to any changes in information about a firm’s future profitability, it is unlikely that any particular actively-managed fund will be able to tell when a stock is genuinely overpriced or underpriced (unless it’s engaged in insider trading!). On average, an actively-managed fund will perform no better or worse than the market – except that its hefty management fees will mean the investor ends up with worse returns than if they put their money into a low-cost passive index fund.

With such management fees taken into account, active funds have consistently underperformed the S&P 500 – see the figure below, courtesy of the S&P Dow Jones Indices annual reports on active fund performance relative to the market benchmark.

Figure 2: Consistent underperformance of active funds relative to the S&P 500 (Source: S&P Dow Jones Indices, via CNBC)

 

How About Bubbles?

Of course, markets are not always rational. Bubbles do form, as has happened with GameStop, where investors have become irrationally optimistic about a stock when in truth its prevailing price vastly exceeds its fundamental value (as dictated by its expected future dividends).

The obvious upshot of bubbles is that one should be wary of piling into a rising stock that the public is enthusiastic about – it is virtually certain that the stock is being driven above its fundamental value and will crash sooner or later.

And while the irrational exuberance of the market may seem exploitable, this is a false opportunity, at least for most ordinary investors. Theoretically, the existence of a bubble gives an opportunity for a clever investor to do some short-selling. Short-selling is when you borrow a stock before selling it – only to buy it back later, and return it to its original owner. If a stock is in a bubble and is grossly overpriced, short-selling can – if you time it right – be profitable. You can sell it when prices are high, and then, when prices crash, buy it back and return it to the person you borrowed the stock from, making a tidy profit on the difference.

The problem, of course, is that timing the market is extremely difficult. If you get in too early, you’ll be forced to take massive losses through borrowing and selling a stock – betting that it’ll crash – only for prices to continue going up, and for you to have to buy back the stock at a higher price than what you sold it for. The lesson here is that the market can stay irrational longer than you can stay solvent, so stay away from trying to time market bubbles.

Conclusion

The trick to clever and profitable investing is to realise that it is incredibly difficult for a single ordinary person to beat the market, and that is fine. Passive investment in an index fund will yield excellent returns as the overall stock market rises, while those who go with active-funds pay higher fees and get worse returns. Meanwhile, those foolish enough to play around with bubbles risk getting ruined.

Investing is, in many ways, a choice. You can think of it as work – boring, but a stable source of income for sobriety and prudence. Or you can think of it as a casino – where one bets it all to win it all. While the latter is certainly an option, be sure to remember: gambling is just a tax on those who didn’t do the math, and the house always wins.

 

Joel Tan, Senior Associate Consultant and Economist at Future-Moves Group, is a graduate of the University of Oxford and comments mostly on developments in global current affairs, politics and economics.


Disclaimer: The views expressed in this article are those of the writer and do not necessarily represent those of Future-Moves Group. Additionally, this article is based on personal opinion and experience and should not be considered professional financial advice. Prior to making any investment or entering into any transaction, you should carefully consider your financial situation and consult your financial advisor(s) in order to understand the risks involved and to ensure the suitability for you of any investment or transaction.