Cost Matter in all forms of Efficient Markets

John C. Bogle the renowned name in the mutual funds shared some thoughts long back saying Whatever the form of theA EMH, I know of no serious academic, professional money manager, trained security analyst, or intelligent individual investor who would disagree with the thrust of EMH: The stock market itself is a demanding taskmaster. It sets a high hurdle that few investors can leap.

University of Chicago Professor Eugene F. Fama had performed enough analysis of the ever-increasing volume of stock price data to validate this “random walk” hypothesis, rechristened as the efficient market hypothesis (EMH). Today, the intellectual arguments against the EMH religion are few. The church, however, has three different dogmas. Princeton Professor Burton Malkiel describes them: the weak form (stock price changes over time are statistically independent); the semi-strong form (prices quickly reflect new value-changing information); and the strong form (professional managers are unable to accurately forecast the future prices of individual stocks).

While the apostles of the new so-called “behavioral” theory present ample evidence of how often human beings make irrational financial decisions, it remains to be seen whether these decisions lead to predictable errors that create systematic mispricings upon which more rational investors can readily capitalize.

Bogle shared his vision of 1951 when he entered into this business, He first heard that era’s pungent description of behavioral theory: “The crowd is always wrong.” (While I’m inclined to agree with that formulation, I’d substitute usually for always.) But I remain mystified about just how it is that “the crowd” can be wrong when, in the (essentially) closed system that is our stock market, every seller must be met by a buyer, and vice versa. Such a match, of course, is not necessary in each subset of the system. Indeed, in the mutual fund subset the crowd is almost always wrong. Investors are legendarily indifferent to buying equity funds until a bull market is well underway, but pour staggering amounts of capital into them as the subsequent and inevitable bear market approaches. To make matters worse, the objects of investor affection are usually the funds with the highest past performance, which of course are about to suffer the largest declines.

But the EMH may well prove less important in investment theory than a new wisdom that is beginning to emerge. I call it the CMH: The Cost Matters Hypothesis. Like the EMH before it, the CMH posits a conclusion that is both trivially obvious and remarkably sweeping: The mathematical expectation of the speculator is a loss equal to the amount of transaction costs incurred. When he concluded otherwise, that “the mathematical expectation of the speculator is zero,” Bachelier was wrong.

So, too, the mathematical expectation of the long-term investor is a shortfall to the stock market’s return, a shortfall that is precisely equal to the costs of our system of financial intermediation—the sum total of all those advisory fees, marketing expenditures, sales loads, brokerage commissions, transaction costs, custody and legal fees, and securities processing expenses.
We don’t need the EMH to explain the dire odds that investors face in their quest to beat the stock market. We need only the CMH. Whether markets are efficient or inefficient, investors as a group must fall short of the market return by the amount of the costs they incur. And since the cost of our intermediation system is relatively stationary over short periods, the impact of that cost is inversely correlated with the returns on stock prices (i.e., a 3% annual cost would consume one-fifth of a 15% market return, but fully one-half of a 6% return.) Even for investors who incur more modest costs (say, 1% per year), the odds are that 95% of them will fail—often by huge amounts—to earn the stock market’s return over an investment lifetime.

Investment professionals need not—indeed since time is money to our clients, must not—wait to act until those studies confirm much of what our intuition tells us already—things that are, well, “both trivially obvious and remarkably sweeping.” We must be figuring out how to take a major chunk of costs out of our system of financial inter-mediation eliminating excess capacity, as the economists would say—so as to reduce the burden of costs and taxes on our clients. And it’s high time we become more serious about accepting the merits of passive all-stock-market investing as a separate and distinct asset class. It is never too late to begin to build a better world for the investors of tomorrow.

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