No knockout punch

There’s this little intellectual quirk of logic that seems to bedevil many people who give serious thought to the relative merits of both active and passive approaches to investment management. As has been noted previously, both sides have some degree of validity and neither side has (to date, at least) managed to score a “knockout punch” to demonstrate an unequivocal superiority. It’s entirely possible that none ever will.

Still, the logic of the exercise leads to some potentially fascinating decisions if one accepts the premise behind choosing one option over another. For instance, the active management approach takes the position that securities are often mispriced and that, through fundamental and/ or technical analysis, disciplined execution and superior trend identification, mispriced securities can be reliably identified and those mispricings can be exploited to the benefit of the investor.

INFERRED ARBITRAGE Let’s take a look at the logic. If a mispricing can be reliably identi- fied and exploited, identification and exploitation are likely to persist until such time as it no longer exists. If a $10 stock could be reliably identified while it was trading at $8.50, for instance, smart people would continue to buy it until the price hit $10. If someone offered you a dollar for 85 cents, you’d be happy to make the trade. Of course, if someone offered you a dollar in exchange for 98 cents, you’d happily make that trade, too – especially if you could do it tens of thousands of times over. Sure money is sure money any which way you slice it.

That’s the thing about market inefficiency. Anyone who believes mispricings exist and can reliably be exploited must also believe that the end result of that exploitation would be the lack of further mispricings. At some point (for example, the point where someone started offering you a dollar in exchange for four quarters), you’d stop playing this game because the inferred arbitrage opportunity that caused you to play in the first place would no longer exist. If mispricings can truly be exploited, it only stands to reason that they would be exploited with impunity. Sort of like the cod stocks on the Grand Banks.

On the flip side, people who favour the viewpoint that markets are already highly efficient (that there are no more mispricings that can be reliably exploited) are likely to act accordingly and stop analyzing active security selection. Why would any rational person spend time, energy and money in trying to exploit mispricings if that person was simultaneously of the mind that those mispricings did not exist? Of course, if everyone took this view, thoughtful analysis would stop and mispricings would seep right back into the system.

This leads to something I call “the irony of acceptance.” It seems to me, no matter which way the majority of people act, the opposite view is likely to be more correct and appropriate since the market is like a selfcorrecting price mechanism. As such, it probably pays to be a contrarian. To whit, if everyone is doing things one way, that might well be the surest indicator that the other way is likely to be better.

Economists have a somewhat pejorative term called “free riders,” where a group of people takes advantage of a fortuitous circumstance that happens to crop up. Think of people who follow ambulances at breakneck speed with the rationale that they’re unlikely to be pulled over. The irony of this is that passive people are rather like the ultimate free riders who take advantage of the diligent work and shrewd insights of stock pickers.

John De Goey, CFP, is the vice president of Burgeonvest Bick Securities Limited (BBSL) and author of The Professional Financial Advisor II. The views expressed are not necessarily shared by BBSL. You can learn more about John at his Web site: www.johndegoey.com.