A client emailed me the other day and mentioned how crazy the investment markets seem to be these days. I agreed with her in an email response and her comment got me to thinking about the nature of investment markets and why they seem to be crazy. Here is my conclusuion.
#1. Markets are efficient. Due to regulatory oversight, markets are efficient when it comes to information. That is, most of the information about a security (the stock of a company, for example) is available to all individuals all the time. That’s what meant when the academics say a market is “efficient.” The SEC has very strict rules to make sure investment markets remain efficient in this sense too. You’ve heard of insider trading violations? That’s what happens when someone on the inside trys to take advantage of information that is not publicly available to make a profit. Markets are not perfectly efficient either. Just very efficient.
#2. Markets are irrational. It’s people who are making investment decisions all the time. Individuals make guesses about the future and then decide to buy and sell. And when people are making guesses about the future, markets are irrational. For example, when the Greek government announces to the public (remember that markets are efficient users of information) that they are instituting harsh economic measures to cut their government spending, people in the investment markets all wonder “what does this mean for the future?” and make decisions based on their guess about the future. By its nature, guessing about the future may be more logical or more emotional. But it’s always a guess and sometimes our guesses about the future are crazy.
These two observations lead me to once again suggest that the best way to invest is to index across different asset classes because if markets are irrational (and they are), there is no way to guess which way they’re going to go. Diversified index investing covers all your bases for your time horizon and gives you the confidence to know that no matter what information comes out and no matter what guesses the experts make about the future as a result of the new information, you’re investments will be fine.
Does that make sense to you?