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## Monday, October 26, 2015

Note: Please see the opening note there. It applies here too.

A large number of papers, journals, websites, and even television channels are devoted to the subject of dispensing investment advice to the general public regarding which stocks or other securities to buy or to sell. If one finds such discussions entertaining, these may be good venues to visit. However, if one expects to earn money, all of these are completely useless. All that almost everybody needs to know about investing in capital markets follows here:

Three rules of investing in capital markets:

1. The market knows everything you do and before you do. The market is smarter than you. You can never expect to earn an additional return by betting that your estimate of the value of some security is better than the market’s, that is, by buying or selling individual securities.

2. Exception to Rule 1. Sometimes, some people do know something the market does not and could profitably trade on this knowledge. However, these people are almost always legally barred from trading on that information by the ban on insider trading and similar restrictions. If you do trade on such information, you may earn money but don’t get caught.

3. Exception to Rule 2. Somebody, somewhere must be some combination of better-informed regarding some security, smarter, and more liquid than everybody else in the world.This conclusion almost follows by mathematical necessity from the fact that there are only a finite number of humans. If you can reasonably believe that you are that unique person, by all means do trade on this basis and may your billions never cease to multiply! If you are merely smarter or better informed than the average bear, you still cannot earn excess returns by picking stocks.

Some reader may be tempted to respond with exasperation: There he goes again, believing that markets are infallible and worshiping his market god. Such reader can be assured that the author by no means believes that markets are infallible for reasons both theoretical and observational:

After all markets are just made up of fallible people with limited knowledge and intelligence. Even markets, the best known mechanism for aggregating such fallible data, cannot achieve infallibility. All they can achieve is the best estimate available to human reason.The reason that one should place greater faith in market estimates than those of other institutions is that markets, almost uniquely among human institutions, do not punish those who disagree with them; to the contrary, markets richly reward those who correctly disagree with the market and readily adjust themselves to these corrections. So if a person—as some may have from time to time—discovers a predictable market miss-estimate of the value of some security, that person can use this market error to become fabulously rich, while at the same time changing the market estimate sufficiently as to dissipate the error. Markets are the Borg.

Even if the theoretical argument for the fallibility of markets fails to convince, the markets themselves admit their own fallibility every single time a price changes:

Financial instruments, in contrast to most other goods, do have an exact, objective determinable value: the present value of all future cash flows from the instrument, discounted by the market rate for risk-free debt. While nobody knows what these cash flows will be, one day—when the last bond matures or the last share is converted to some other form—we’ll be able to retrospectively determine this exact value.

So if a stock was traded at $9 yesterday and$10 today, then these two prices can’t both be equal to the objective value of the stock. So the market erred at least once and most likely both times.

All of the above is directed exclusively at those who believe that they can improve their expected return by listening to stock pickers. For people who do not think so, but just enjoy gambling a little bit, picking stocks is an excellent idea. The odds are better than in the casino and much, much better than at the government lottery.Indeed the author has often wondered why the markets haven’t put state lotteries out of business by creating financial products with the same price and risk profile as lottery tickets, but much better payout ratios—99%, rather than the 50% or so of state lotteries. Some variation of a deep out-of-the-money option should work. Perhaps a brother with greater expertise in securities regulation can explain?