Adam Smith Was Right: Excess Profits Get Competed Away

Includes: HDG, HEDJ, SPY
by: Tim Worstall

Felix Salmon has a nice post and chart here, essentially showing that hedge funds trading US equities aren't doing any better (or perhaps even anything different) than the general stock indices themselves. This may be true, but the real point to be made is what this tells us about past performance being no good guide to future such. And most importantly, that high returns in one activity or sector at one point in time do not mean high returns in the same sector at other, future, points in time.

Here's Felix's chart:

Click to enlarge

OK, so we can see returns approaching, over time, the general return to the market.

My point here is that the reason for this was explained by Adam Smith 235 years ago. He pointed out that there was a natural, or general, rate of profit in the economy. Yes, risk adjusted and all that, but still a general rate. Now, sometimes, if you're clever or lucky, you can make in excess of that rate.

Perhaps a new technology, a new product, a new method of organisation. But your fellow capitalists, just as hungry for profit as you are, are going to note that you're making those excess profits. So they're going to start investing in your field, copy your methods/technologies.

Given that any market opportunity is limited to some extent more capital chasing those excess profits is going to reduce them, eventually leading to this formerly excessively profitable sector having the general profit rate again. In general economics terms we're just fine and dandy with thius for it's that hunger for the excess profits that leads to technological advance.

But in terms of investing it's a terribly important lesson to understand. That a sector currently has excess profits does not mean that they are going to continue: far from it. It means that there are hundreds to millions just like you who have spotted those excess profits and who will, by investing to chase them, destroy them.

Sadly, by the time we all know about excess profits they're on their way out because we all know about them. Therefore the trick is to find those sectors which are about to enjoy excess profits and that, sadly, is a much more difficult trick to pull off.

And as Felix points out, stock market hedge funds seem to have run their course, from non-existence to excess profits to now just the general rate of profit.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.