Who Wants to Be a Millionaire?

You've undoubtedly seen (or at least heard of) the hit television show that goes by the above title. It's basically a trivia contest. If a contestant gets stuck in their quest for the big prize, they have one shot at polling the studio audience for help. So what does this have to do with investing?

The way the stock market works is analogous to polling a large audience of investors. As an investor, you can cast your vote for any publicly-traded stock. A buy order reflects your belief that the stock will go up, while a sell order indicates that you think the stock will decline. Throughout each trading day, the market tallies the votes and adjusts the stock price almost instantaneously. If there are more buys than sells the stock price rises, and vice versa.

Just how efficient is this process? Polling the studio audience on the "Millionaire" show usually provides the right answer, but not always. Let's imagine that we had some influence with the show's producers and could change the rules. To make it more like the stock market, we'll allow anyone in the country to submit an email vote for $100. The entry fee will serve as a double-or-nothing bet; a wrong answer and you lose the $100, while a correct choice gives you a $200 payoff. Participation is strictly optional; if you don't know the answer you don't have to vote. Given this new set of rules, it seems unlikely that the audience would ever get a question wrong.

With the game-show analogy in mind, think of stock market investors as a myriad of self-interested players competing to earn the greatest returns on their investments. If they have special knowledge about a particular industry or company, they can cast their vote for buy or sell, with real money at stake. If they have no opinion about a company they can stay on the sidelines. Of course, no investor knows everything about a particular stock. They may be too optimistic or too pessimistic about its future prospects. But these errors seem to cancel each other out. The net result is that the market distills innumerable bits of knowledge from different market players into a single number. This number, the stock price, reflects the opinions of all types of investors, including amateurs, professionals, individuals and institutions. Any future movement in the stock price will only occur as new information comes to light.

This all sounds very theoretical, but it has been borne out by empirical research. Since the introduction of reasonably powerful computers in the 1970s, there has been extensive investigation into the behavior of stock prices. Financial economists have discovered that future stock prices are unpredictable and it is difficult if not impossible to capture returns greater than the overall market returns without assuming greater than market levels of risk. In other words, it is futile to try to pick undervalued or overvalued stocks because the market has already priced them appropriately based on present knowledge.

What does this mean for you as an individual investor? We'll address that question in depth in future installments. For now, let's jump right to the conclusions and fill in the blanks later. If you want to be a millionaire, don't get swept away by investing hype. Invest for the long haul, diversify your holdings, and stick mainly to index funds and other forms of passive investment. Finally, don't forget to take a sober view of risk and pay close attention to taxes and fees.

September 1, 2000

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