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- [Tyler] We saw in earlier videos that markets respond quickly to new information,
and often times, accurately. This is sometimes called, The Wisdom Of Crowds.
And this leads us to Investment Rule #4: Even if markets are sometimes
imperfect or irrational, do not try to beat the market. Markets can be wiser than
any individual trader. Ultimately, markets are constrained by the rationality of
traders, but traders themselves are not always rational. People have all kinds of
biases. They can be overconfident. They tend to follow the herd. They're not
always very numerate, and the list goes on. It's not surprising, therefore, that
markets don't always behave efficiently.
Markets, for instance, tend to be more volatile than might be expected from
rational factors alone. Robert Shiller won a Nobel Prize in Economics for his work in
this area. There are also market anomalies we've seen over the years, things like the
Monday Effect and the January Effect, which say that stocks tend to fall more on
Mondays than on other days, or maybe they increase more in Januaries than in other
months. There has been some evidence for these effects, but the effects tend to
disappear once investors learn about them. More stable, perhaps, is the Momentum
Effect, which says that past performance does predict future performance at least a
little bit. In particular, portfolios that buy past winners tend to outperform in the
medium term. This could happen because, although investors respond to information
in the right directions, they sometimes underrespond.
For instance, good news is not always fully reflected right away in prices. And
so, buying past winners can sometimes yield extra profits. But I would stress, this is
by a very small amount. In a course on what is called "Behavioral Finance," we
would spend more time on these possible price anomalies and different explanations
for their presence. In this talk, however, I'd like to focus on the most important
points for you as a personal investor. At the end of the day, market inefficiencies
or not, the market is still really hard to beat. Remember that despite some possible
market inefficiencies, most money managers don't beat the market, and even fewer do so
year after year. So, should you try to beat the market? No. Don't forget that
you, too, are subject to overconfidence. You probably don't update probabilities
perfectly efficiently. And when the stock market is crashing, you too are likely to
behave more emotionally than you should.
In short, most of the time, the market is probably more rational than you are, even
if all of us are a little crazy at times. Even the great investor, Warren Buffett,
who at times has beaten the market himself, doesn't think that most other
investors should try to do the same.
- [Warren Buffett] I got a dual answer that. If you are not a professional
investor. If your goal is not to manage money in such a way as to get a
significantly better return than the world,
then I believe in extreme diversification.
- [Tyler] In fact, Buffett has told his heirs, "Don't do what I do. Invest in general,
well-diversified index funds instead." We agree. And so the takeaway here is: even if
markets are inefficient or irrational, you still shouldn't try to beat the market.
- [Narrator] Check out our practice questions to test your money skills. Next
up, we'll tackle housing. Rent or buy?
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