Here's Where You Might Be Defying Common Sense With Your Investments

Posted by Alex Frey (@alexhfrey )
Sometimes a little of it goes a long way...

If you were looking to buy a new car, would you consider it rational to ignore price and base your decision entirely on horsepower?

Most people who don't have Bill-Gates levels of wealth would probably say no. Even if you can afford a more expensive car, you may rationally opt for a cheaper one if you think it is a better value.

Yet when it comes to purchasing investments for their retirement, many of those same people totally ignore price when determining their portfolio composition.

If you don't think this could possibly apply to you, think about it for just one second, you might be surprised.

Perhaps you have based your portfolio composition off one of those popular finance articles suggesting that you might own a balanced portfolio of, say, 60% stocks and 40% bonds? Well, where exactly does price factor into that? The stock market could double and the bond market get cut in half, and the 60-40 rule wouldn't change one bit.

The way that most people invest, the only role that price plays is determining how many absolute shares of an investment they end up buying. Which investments they actually purchase are determined some other way, such as reference to a popular rule, or by analyzing some kind of historical returns, without taking into account that those historical returns were achieved at a different price than the one today.

If it would be irrational to ignore price when it comes to buying a new car, can it possibly be logical to ignore it when it comes to planning for your retirement?

One Reason It Might Be Rational To Ignore Prices

A lot of finance professors would vehemently answer that question with "Yes! Ignore price completely and you will be better off." And they actually aren't totally crazy for thinking so.

Their logic is based on something that we have mentioned before called the Efficient Market Hypothesis (often abbreviated "EMH"). EMH argues that in a competitive market where professional investors and traders are constantly trying to exploit whatever "edge" they can get, prices should always reflect all known information. If they didn't, then there would be a way to earn a risk-free profit. But if enough people see that profit and trade accordingly, they will impact prices and the potential for the profit will go away.

If you think that the price of the different assets in the market is always "right", then it is clearly not advantageous to pay much attention to them. Instead you should just decide how much you have to invest, and trust that you are buying assets for their "fair value." This is, in fact, what most people, even most professional financial advisors, do (see "The First Grand Theory of Investing: Strategic Asset Allocation").

Here's Why Price Matters

There are actually two kinds of market efficiency to wonder about. First, we might posit whether the prices of different assets at a single moment in time are efficient in relative terms, i.e. is Pepsi efficiently priced relative to Coke? Second, we might wonder whether prices are efficient across time, i.e. is Pepsi efficiently priced relative to its price yesterday, or its price three months ago?

While it's still far from an airtight argument, it turns out that it is far easier to make a case for the first kind of efficiency than the second.

To make a long story short, there are just too many reasons to think that prices across time are not particularly efficient, i.e. changes in stock prices reflect something beyond just changes in the underlying fundamentals of an economy or a business.

One common-sensical reason to think this is that we know that from time to time prices go completely crazy. Nuts. Insane. Loony.

We call these times "bubbles."

One of them occurred in the late 1990s when anything with ".com" appended on the end of its name would IPO and go off to ridiculous levels.

Another happened with houses in 2004 - 2007, when people began to assume that double-digit annual increases in their house price were to be expected.

Most people today are familiar enough with these kinds of "bubbles" that they accept their presence.

Is it really logical to think that prices are occasionally totally off the wall and crazy, but at all other times are 100% correct and rational? I can't see any argument for why that would be the case. In fact, it seems impossible. 

If prices are totally crazy sometimes, then it seems likely that at other times still they are only moderately crazy. So the efficient market theory is starting to go out the window pretty fast... 

Sometimes the Common-Sense Notion of Something Really is True

The EMH hypothesis is a strange beast. If you know nothing about modern finance but have a strong common sense about you, you will probably find it initially quite obvious that the attractiveness of a particular investment will heavily depend on its price.

Then when you start to learn a little bit about academic finance, you will probably start to change your mind. The EMH (and this is also true for much of "academic" finance in general) has a seductive logic that tends to pull people in. If you take enough finance or economics classes, you will want to believe in it, because the theory is so logically compelling.

But here's the strange thing. The deeper that you go, the more that you learn, and the more closely you look at the data, the more likely you are to go back to your initial common sense notion. Price really does matter.

And sometimes a little common sense really does go a long way.

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By Alex Frey