Free lunches do exist in the stock market.
I am motivated to write this week, as often I am, by some reader comments.
It is though an old topic of debate all over the investment world, but which gets resurrected regularly, most commonly by newcomers looking at the stock market.
Another group who will frequently bring up the point are not newcomers, they may actually have quite a lengthy experience of shares, but have been quite unsuccessful at it over time and therefore become disillusioned, most likely because they tried to trade frequently and failed, because most active traders fail.
The topic to which I am referring is the belief that there is no free lunch (NFL) in the stock market.
What people mean by this is that no particular approach is likely to beat the market consistently over time. Consequently, there is no point in even searching for such ideas and you may as well just invest in index trackers. Similar to the Efficient Market concept.
There are a couple of reasons typically advanced for this and I’ll demolish them here.
One is that if there were free lunches then everyone would follow them, so that the advantage would quickly be arbitraged out. The other is that information is public, so that nobody can derive an advantage over others from it.
You can’t predict humans
Both reasons, though, are based on the assumption that humans are entirely rational and logical, so that their actions are always a result of such thinking and that they never act in irrational or illogical ways. That is so obviously untrue that it hardly requires evidencing.
Look around you, even look at yourself, do you see purely rational and logical behaviour all the time, even in financial matters?
But I can take this further, because not only are people not always rational and logical, even if they were, that still does not mean that with investing they would always react the same way to any situation requiring decisions.
And that is because investing lacks any precision or universal laws, unlike science.
Everyday science has little room for personal opinion but investing is virtually the opposite, much more of an art and consequently where opinion is over riding.
Take two investors…
Thus take two investors, and let’s assume they are the perfectly rational and logical ones believed in by NFLers. Such individuals don’t exist, but let’s assume for the moment they do because I need to create them in order to destroy them.
Even these two investors will sometimes disagree on a share, or a course of investment action, simply because the whole process is very much a matter of opinion and interpretation.
And if these two fantasy investors can disagree, and it is certain they will at times because of the substantial element of personal opinion, how can there be much conclusion drawn from the actions of the real but to some extent irrational and illogical investors out there?
Now look again at the two main reasons for NFL believers.
My first is that if there really were outperforming strategies, they would be quickly arbitraged out because everyone would then adopt them.
If everyone did this, then it would be true. But in practice everyone doesn’t do this, and that’s why some strategies can outperform over time, even whilst taking no more risk.
There are two reasons why everyone wouldn’t follow something that appears to be successful.
Firstly, their investment objectives will vary widely. Someone investing long term for income is unlikely to be persuaded by a short-term trading strategy and vice versa. An investor who likes emerging markets is not going to follow a dividend based approach and so on.
Secondly, they simply may not believe in the idea. There are an enormous number of strategies to investing and I would agree that most of them are probably useless, appearing to offer outperformance, but which were just a favourable blip for a time.
People love to identify patterns where they don’t exist. So, if you have seen large numbers of approaches over time that appeared at first to do well but went on to do poorly, you become cynical. I’m pretty cynical myself having seen most things over the years.
The second of the reasons given for the NFL view, that company and other information is all public, is clearly true. But it does not follow at all that no advantage can be gained as a result. That’s because this is not a science and we’re back to personal opinion of a given set of facts about a share.
Big companies versus small companies
Anyone with the slightest experience of the market will be aware that differing views will exist on the same share. It is commonplace.
Another point is that big companies are far more widely researched than small ones. And on top of all this, those views will be given by people who are not wholly rational or logical because such people do not exist.
Note too that even if there is a strong consensus about something, it still does not offer certainty that it must be correct. That’s because a further feature of humanity is its tendency to follow others even if the course being followed is on close examination quite crazy. We’re not cats, we’re sheep in the main.
Yes Free Lunch
My conclusion is that the NFL view is wrong for the reasons I’ve advanced, and I conclude that there is Yes Free Lunch. But I’m not saying it’s easy to find one.
A lot of ostensible free lunches will give you food poisoning and beware the proof of a strategy by back testing. That’s used often to try and demonstrate the validity of a strategy but it has a nasty habit of failing to follow through in future.
A free lunch requires thinking differently from the crowd and that is difficult for most investors I’d guess, and it requires a certain type of personality involving great patience and self belief for long periods.
Value investing in my opinion is an example of a free lunch. It will only ever by definition be a minority activity and won’t always work either. There will be times when it doesn’t, and times when some shares go wrong, but overall and over time, I believe it does so.
This article, written by Stephen Bland, was originally published on Fool.co.uk. Bruce Jackson has updated it.