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An Interesting Way To Think About Efficient Markets – Mental Models, Analogies, And The Differences Between Investing And Speculation

Summary

Analogies of efficient markets exist in our day-to-day lives. See how these analogies can improve your investing ability.

By: Sean Gurson

December 27, 2017

If you are not familiar with the Efficient Market Hypothesis, you can read about it here: Efficient Market Hypothesis - EMH

If you are not familiar with the differences between investing and speculation, or the differences between defensive investors and enterprising investors, then I suggest you read “The Intelligent Investor”, by Benjamin Graham.

The stock market is efficient because stocks reflect publicly available information about them and you are not supposed to be able to earn outsized returns as a result. If you are familiar with the various forms of the efficient market hypothesis--whether or not you think it is true--I would like to offer a mental model or analogy on how the markets operate and why I believe stock markets are generally not perfectly efficient. In other words, this model is one way that I think about the stock market that explains why you CAN beat the market.

Have you ever been waiting in line at the grocery store, say Target (NYSE:TGT) or Safeway, and wondered which line will be fastest? Which line do you choose to checkout all of your items and leave the store as quickly as possible? Should you stick with your first choice or move to another line if it shortens? Many people in a rush would switch lines.

The other day I walked up to the Express lane, 15 items or fewer, of my local Safeway. Beside me stood a friendly police officer who had just stepped into the Express line next to mine. Then, a third gentlemen had to decide between stepping into my line, or stepping into the officer’s line. Clearly, the look on this gentleman’s face told me he was trying to pick the fastest line. After all, it was the holiday season. Everyone was busy and in a rush.

So, I began to think.

Imagine yourself as the third gentleman. First of all, what qualities do you look for to choose the fastest line? Do you count the number of people in the line, or should you count the number of items each customer has to ring up? Should you try to choose an employee who scans items faster than a gunslinger in an old western movie? Or maybe you’re at Target (NYSE:TGT) and thinking about using the self-checkout instead. Which is optimal?

This gentleman chose the seemingly shorter and faster line, the very same one the officer before him had chosen, and probably for the same reasons. I looked the gentleman in the eye and joked, “which do you choose? It’s a race!” I winked. The officer overheard and was also intrigued.

The gentleman explained his rationale. He chose the line that looked shorter. He also noticed the each person in that line had only a few items.

I think most people in the gentleman’s situation would be comfortable stepping into the same line as the police officer had chosen, because after all, he is sharply dressed in uniform and appears to be a sound decision maker. He must know what he’s doing, right?

But I already had a good idea of who would be walking out that door first.

Now for the analogy. Let’s imagine all the checkout lines as analogous to the stock market as a whole, and the individual lines as analogous to the individual stocks of the stock market. The customers choosing a line are akin to investors picking an individual stock. Lastly, let’s imagine the fastest line as the most profitable stock in the stock market.

Everyone choosing a line has access to the same information about that stock, because everyone can see all the details of the line. They can count the number of people in line or their number of items, measure the employee’s ability, etc. This is akin to investors having access to P/E ratios or other public financial data. But how people process that information varies, and this is exactly why markets are not perfectly efficient, markets can be beaten.

Most investors would disregard all of this information, as they should. Much of it is noise. They don’t seek to choose the fastest line. These are defensive investors who should be passively investing in low cost index funds by dollar cost averaging over the long term.

But to the astute few enterprising investors who do wish to earn outsized returns, they must not only measure the various factors, but also determine how heavily to weigh each of them. They must process the publicly available information in a more intelligent way. As stated in the “Intelligent Investor” by Benjamin Graham, you are not right or wrong about an investment because it went up or down after you bought it, you are right because your information and reasoning were right.

As it turns out, as an intelligent, enterprising investor who has experienced some painful financial lessons, I was already prepared for this investment decision because I had already thought about it carefully. I chose the line with fewer people, even though they had lots of items in their carts. The reasoning is, the transactions per individual take a long period of time, so even if each person has a few items, they generally have to swipe their cards and sign, type in their phone numbers, etc.

The line with the officer and gentleman began to shorten. I began to have feelings of regret about my original decision that I had to deal with mentally. I thought about switching into their line and joining their team, after all it would be so much easier and less embarrassing if their line finished first. Why was I becoming so stressed over nothing? How could I be so dumb?

Do you see how my feelings were not unlike the madness of crowds? In other words, it was market folly. I wanted to do what everybody else was doing. Herd mentality. I was becoming emotionally involved with the ups and downs of my investments, instead of using the market’s volatility to my advantage. By switching lines because the other line seemed to be moving faster, I would have been essentially buying because stocks were going up and selling because stocks were going down. If this sounds like something you would have done, then you are a speculator. You are not an investor.

A speculator cares too much about unpredictable ups and downs in price, with no understanding of value. An investor thinks about price versus value, buys when prices are below fair value, and sells when prices are above fair value. He believes markets are efficient enough that prices will reflect fair value over the long term. Investors enjoy buying items in a grocery store when they are on sale just as they enjoy making investments when they are selling for a discount.

If you have some sort of limiting beliefs about the stock market, for example, that it is somehow manipulated to line the pocketbooks of government officials, or that it is a Ponzi scheme, or perhaps you have been burned in the past, then I suggest you stick to doing the things you know and staying out of the market entirely. Focus on your job or other sources of income. But keep in mind, millions of Americans invest in stocks successfully over the long term, passively, month by month, (think of 401ks) and they are likely no different than you in their reasoning faculties. Heck, over the past nine or so years, you could have crushed the markets investing in names like McDonalds (NYSE:MCD), Starbucks (NASDAQ:SBUX), Costco (NASDAQ:COST), Home Depot (NYSE:HD), etc.

If you are a speculator, then I challenge you to grow by learning about stocks as investments, lowering your return expectations, and focusing on long term decisions.

Owning stocks since 2009 has made those who invested in stocks even richer, while those Americans who remained on the sidelines lost out not only on the potential returns but also saw the purchasing power of the “safe” cash they held deteriorate significantly due to inflation.

Fortunately, in the end, I stuck with my original decision and decided to wait it out in the first line I chose. My line eventually caught up and I began my transaction before the officer did. Before I turned to walk out the door, I looked at them, waved goodbye, and winked.

It’s okay to speculate, invest, or stay out of the markets entirely, but if you see me at the grocery store, don’t expect to beat me out the door.

If this article made sense to you, here are some additional questions to ponder to improve your investing ability.

Do you see any other similarities between this common situation at the grocery store and the real stock market? How do real world investors behave similarly to the officer, the gentleman waiting in line, and to the author of the article?

Can you come up with an entirely different analogy between efficient markets and the flow of automobile traffic on the highway? Which lanes move faster during rush hour? Should you weave in and out of different lanes or stick to one lane? What factors determine the flow of traffic and the changes in speed of traffic within each lane?

Disclosure: This is not a recommendation to buy or sell any securities. The author does not have any financial interest in any of the mentioned securities at the time this article was written and has no plans to take a financial interest in any of them in the foreseeable future. This article is entirely the opinion of the author and is meant for informational purposes.

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