Enrich Your Future 06: Market Efficiency and the Case of Pete Rose
My Worst Investment Ever Podcast
Challenges in Generating Alpha and Market Efficiency
This chapter delves into the difficulties active managers face in outperforming the market due to the increasing efficiency of financial markets and the diminishing opportunities for alpha generation. It explores factors like the transition from alpha to beta, the hunt for market inefficiencies amid growing competition from hedge funds, and the constraints on arbitrage activities.
In this episode of Enrich Your Future, Andrew and Larry Swedroe discuss Larry’s new book, Enrich Your Future: The Keys to Successful Investing. In this series, they discuss Chapter 06: Market Efficiency and the Case of Pete Rose.
LEARNING: Don’t try to pick stocks or time the market.
“The evidence is very clear. The stocks retail investors buy underperform after they buy them, and the stocks they sell go on to outperform.”
Larry Swedroe
In this episode of Enrich Your Future, Andrew and Larry Swedroe discuss Larry’s new book, Enrich Your Future: The Keys to Successful Investing. The book is a collection of stories that Larry has developed over the 30 years to help investors as the head of financial and economic research at Buckingham Wealth Partners. You can learn more about Larry’s Worst Investment Ever story on Ep645: Beware of Idiosyncratic Risks.
Larry deeply understands the world of academic research and investing, especially risk. Today, Andrew and Larry discuss Chapter 06: Market Efficiency and the Case of Pete Rose.
Chapter 06: Market Efficiency and the Case of Pete Rose
Many people have difficulty understanding why smart investors working hard cannot gain an advantage over average investors who simply accept market returns. In this chapter, Larry uses an analogy in the world of sports betting to explain why the “collective wisdom of the market” is a difficult competitor.
The case of Pete Rose
Pete Rose was one of the greatest players in the history of baseball, finishing his career with more hits than any other player. It seems logical that Rose would have a significant advantage over other baseball bettors.
Rose had 24 years of experience as a player and four years as a manager. In addition to having inside information on his own team, as a manager, he also studied the teams he competed against. Yet, despite these advantages, Rose lost $4,200 betting on his own team, $36,000 betting on other teams in the National League, and $7,000 betting on American League games.
This reveals that if an expert like Rose, who had access to private information, could not “beat the market,” then it’s very unlikely that ordinary individuals without similar knowledge would be able to do so.
Sports betting market efficiency
Larry shares other examples of the efficiency of sports betting markets. One such example is a study covering six NBA seasons in which Professor Raymond Sauer found that the average difference between point spreads and actual point differences was astonishingly low—less than one-quarter of one point.
In horse racing, the final odds, which reflect the judgment of all bettors, reliably predict the outcome—the favorite wins most often, the second favorite is next most likely to win, and so on. This predictability of the market further emphasizes the futility of trying to exploit mispricings and the need for a more reliable investment strategy.
Larry goes on to quote James Surowiecki, author of “The Wisdom of Crowds,” who demonstrated that as long as people are acting independently (not in herds), they exhibit what might be called “collective wisdom.” With regard to sports betting, that means the market’s collective wisdom in setting point spreads (or odds) is tough competition to overcome, especially after the expenses of the effort. Larry advises sports bettors to have a small entertainment account to bet on their favorite team and not to invest their entire retirement account. The same holds true of investing.
The market’s collective wisdom in setting prices is a difficult competition to overcome, especially after the expenses of the effort. Recognizing this, prudent investors don’t attempt to beat the market by trying to exploit mispricings. Instead, they invest in a globally diversified portfolio of funds (such as index funds) that invest systematically and do so in a transparent and replicable manner. In that way, they earn market returns and do so in a highly tax-efficient manner. And the evidence demonstrates that they outperform the vast majority of investors —institutional and individual.
No retail investors to exploit
The evidence is clear. On average, the stocks retail investors buy underperform after they buy them, and the stocks they sell outperform. The problem is there aren’t enough retail investors to exploit because they’re smart, talented, and have access to the best databases. But still, the market is too efficient, and the competition’s too tough.
Larry insists that retail investors shouldn’t try to pick stocks or time the market unless they have different information. This advice is crucial for investors, guiding them away from risky strategies and towards more reliable investment methods.
Further reading
- Douglas Coate, “Market Efficiency in the Baseball Betting Market: The Case of Pete Rose,” Rutgers University Newark Working Paper 2008-003, January 2008.
- Raymond D. Sauer, “The Economics of Wagering Markets,” Journal of Economic Literature, 36, p. 2021-64.
- James Surowiecki, The Wisdom of Crowds (Doubleday, 2004).
Did you miss out on the previous chapters? Check them out:
- Enrich Your Future 01: The Determinants of the Risk and Return of Stocks and Bonds
- Enrich Your Future 02: How Markets Set Prices
- Enrich Your Future 03: Persistence of Performance: Athletes Versus Investment Managers
- Enrich Your Future 04: Why Is Persistent Outperformance So Hard to Find?
- Enrich Your Future 05: Great Companies Do Not Make High-Return Investments
About Larry Swedroe
Larry Swedroe was head of financial and economic research at Buckingham Wealth Partners. Since joining the firm in 1996, Larry has spent his time, talent, and energy educating investors on the benefits of evidence-based investing with an enthusiasm few can match.
Larry was among the first authors to publish a book that explained the science of investing in layman’s terms, “The Only Guide to a Winning Investment Strategy You’ll Ever Need.” He has authored or co-authored 18 books.
Larry’s dedication to helping others has made him a sought-after national speaker. He has made appearances on national television on various outlets.
Larry is a prolific writer, regularly contributing to multiple outlets, including AlphaArchitect, Advisor Perspectives, and Wealth Management.
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