Efficient Markets

A core belief and philosophy at Blue Water Capital Management, LLC is that markets are efficient. This means that we believe that market prices are fair, and they fully reflect all available information. We are not saying that markets are perfectly priced, but they represent the collective wisdom of all the participants.

Example:

 

If Microsoft is trading at $35/share, we believe that is its fair value. If you placed a market order to sell 100 shares of Microsoft, would you expect to receive $40/share? No, you would expect $35/share because that is what the rest of the market participants are telling you its worth.
 

Example:

 

Let's say you go to E-Bay to see if you can find a bargain deal on a "valuable" that's worth about $1,000. You find it has a current bid of $250, so you start there. Debbi, also knowledgeable about the "valuable", soon finds it online and enters a bid of $400. You counter with $500, and she with $600. Chances are you will both go back and forth until the bid is close to $1,000. The bargain you thought you found has vanished. The collective knowledge of only two people led to a pretty efficient (fairly-priced) market.
 

A market only needs a few participants to approach efficiency. Think about the investment market and how many participants (money managers, analysts, individual investors, etc.) are involved. You may get away with a "steal" at E-Bay because of poor market knowledge and/or little market participation. But how often do you think you could get away with a "steal" on Wall Street? How is it that the millions of other participants mis-valued your stock? Chances are they didn't mis-value it, you did.

Assets are re-priced every minute of the day according to the news that comes out. As new information enters the market, it is quickly absorbed into the prices of securities, and thus hard to capitalize on. Future stock price movements are dependent upon future news. It is absolutely futile to try to predict the future, and the impact that this news will have on stock prices.

Over time markets go up. The efficient markets belief does not question whether a person's individual stock picks will go up in value, it questions whether that person can consistently outperform the market as a whole. In fact, markets are only getting more efficient. Advancements in technology, like the internet and cell phones, only ensure that people are better connected and more knowledgeable (or at least have access to more knowledge...).

The efficient markets belief is at odds with traditional investment strategies, including most transaction-based Wall Street strategies. It has, however, been supported by numerous academic studies, both theoretical and empirical. These studies show, among other things, that the risk-adjusted returns achieved by professional investment managers are no better than those of the market as a whole (primarily due to the expenses and taxes incurred with active management). This has led to the rising popularity of index funds.

At Blue Water, we don’t try to beat the market; we try to be the market. And by market, we don’t mean the Dow index or the S&P 500 index, we mean the global collective of almost all investments. This ‘global market’ has delivered very good rates of return over time as well as exceptional diversification.

Classic economics joke about market efficiency: An economist and a non-economist are walking down the street. The non-economist spots a $20 bill on the sidewalk and starts to reach for it. "Don't bother," says the economist. "If it were real, somebody would have picked it up already."

It's not to say you can't ever find a $20 bill, but can you make a living walking around picking up money others have dropped? Or more importantly, can you consistently outperform (earn more than the market) by capitalizing on other's mistakes (buying and selling securities that the rest of the world has somehow mis-priced)?

Yes, but it is extremely rare. We would rather earn consistent global market returns than risk years of under-performance in quest of an extra 0.5% one year. Markets are unpredictable and uncontrollable, but there are three things we can control in investing: Costs, Taxes, and your Asset Allocation.

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