Archives for September 2009

I ran across another nice tidbit from the book The Undercover Economist by Tim Harford the other day, which like the concept of price targeting, also manages to involve supermarkets. I guess everyone goes to supermarkets. 🙂

In a chapter exploring stock market pricing, he covers the the idea of rational investors, the “efficient market theory”, and the related “random walk hypothesis”.

You can see the same phenomenon at work at the supermarket checkout. Which line is the quickest? The simple answer is that it’s just not worth worrying about. If it was obvious which line was the quickest, people would already have joined it, and it wouldn’t be the quickest any more. Stand in any line and don’t worry about it. Yet if people really just stood in any line, then there would be predictable patterns that an expert shopper could exploit; for example, if people start at the entrance and work their way across the store, the shortest line should be back near the entrance. But if enough experts knew that, it wouldn’t be the shortest any more.

The truth is that busy, smart, agile, and experienced shoppers are a bit better at calling the fastest lines and can probably average a quicker time than the rest of us. But not by much.

To me, this is a nice and simple way to explain the argument of efficient markets to say, a fifth-grader. If the market price of a stock was a lot lower than the “true” value, people would start buying, and soon the market value would equal true value. Even someone that young can appreciate trying to pick the shortest line, weighing the possibility of getting through quicker with the possibility of ending up actually waiting longer than if I had just stayed put. In the end, how much do you really gain on average?

Relative Efficiency

I would expand this analogy a bit further, however. In the stock market, if you can reliably “beat” the average person by just a few percentage points a year, you would become rich. Really rich. In the supermarket, the prize is a few extra minutes. I think people would agree that a lot more people around the world are trying a lot harder to get rich, than people are trying to get through the supermarket line. In the stock market, you’re trading against professional arbitrageurs and some supercomputer programmed by a genius hired by Goldman Sachs.

Imagine a supermarket full of world-class athletes connected via radio to spotters placed above each checkout line! This constant competition increases the “efficiency” of the market, and therefore makes it much harder to be above average.

Switching Costs

Despite the slight chance of improvement, I still like to try and find the shortest line at the supermarket. But what if I had to pay 50 cents every time I switched lines? I’d probably stay put.

This is similar to what happens when you try and actively trade the stock market. An actively managed mutual fund will cost nearly a full 1% of your total assets a year, while a passive index fund will be around 1/5th that cost (0.20%). Over time, that really adds up. If you do it yourself, you’re also looking at stock commissions. If you spent $10 a trade and bought $500 of a single stock a month, that’s a 2% hit for a buy, and 4% round-trip. High costs are the primary reason why you always hear that actively managed funds don’t outperform index funds.

In the land of investing, you can keep trying to pick the fastest line, but be realistic about the competition and watchful of your costs. By “staying put” with low-cost mutual funds, you’re guaranteed to be above average.

If you’re a corporate “insider” such as an officer, director, or other certain employees, your purchases and sales of stock must be reported to the SEC in order to reduce illegal insider trading. Technically, an insider is not supposed to trade if they have “material nonpublic information” when making the purchase or sale. But still, who would know better?

Therefore, it’s interesting to see how insider trading activity as a whole by comparing the amount of shares being bought and sold during all this volatility, and then compare that with the market. See the graph below compiled in this CNN Money article:

Insiders loaded up overall during the panicky months of February and March, and then seemed to sell off a bit in happy August. I wouldn’t necessarily base future trades on this relationship, but it is definitely food for thought!