Monday, August 8, 2011

Looking for Market Conditions that Favour Active Investing

According to some pundits, we are in a sideways market, which means that stock prices are neither going up nor down. Others say we are in secular bear market, which the Wikipedia entry for market trend defines as “a long-term trend that lasts 5 to 25 years ... [that] consists of smaller bull markets and larger bear markets.”

Implicit in these claims is the prediction that these conditions will continue for the near future. Obviously, index investors can’t make money on their stocks in the near term if stock prices stay flat or tend to drop. A common follow up claim is that these markets are for stock-pickers or other types of active investors.

The problem, of course, is that to beat the market you need to take advantage of those who lose money to the market. To be a market-beating smart investor you have to be able to exploit dumb investors. When the market performs poorly, the only way to get good returns is to beat the market, but that doesn’t mean that it will be easy to do so. Similarly, when gambling and losing, just because the only way to get even quickly is to make a huge bet doesn’t mean that the roulette wheel will land on your lucky number.

The type of market that is best for active investors has little to do with the market trends; it has to do with whether there are many exploitable dumb investors who use active strategies. I see no reason to believe that there are more dumb investors picking stocks when markets perform poorly. In fact, I recall during the dot-com era of explosive stock prices that just about everyone I worked with traded stocks actively.

I don’t believe that anyone really knows what type of market we will have in the near future. But even if they did know that market will perform poorly, I don’t see why one type of market would favour active investing. Even market timers who plan to sell out completely have to match up with someone buying into the market. If this weren’t true, then prices would already have fallen due to too many sellers and too few buyers.

3 comments:

  1. The roulette-wheel analogy is right on!

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  2. @Patrick: Glad you liked the analogy. I was quite happy with it.

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  3. "Similarly, when gambling and losing, just because the only way to get even quickly is to make a huge bet doesn’t mean that the roulette wheel will land on your lucky number."

    That is brilliant!

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