Why Economics Doesn’t Teach How to Pick Stocks

This week I’m answering an interesting question from Bruce from Fort Lauderdale. Bruce has a finance question. He says:

“Let’s discuss beta: Why isn’t beta separated into upside beta and downside beta? As you know, a stock which rises and falls the same as the market has a beta of 1. Consider another stock which, when the market rises, rises twice as fast, but when the market falls, falls by the same percentage as the market. I am taught that this stock has a beta > 1, so it is considered riskier than the market as a whole. In my opinion, that’s ridiculous. I suggest that this stock has an upside beta of 2 and a downside beta of 1. As demonstrated by this example, do you agree that the currently accepted concept of beta is flawed?”

I will weigh in, but I wanted to use this question as an opportunity to highlight some of my limitations in terms of what I can answer. Specifically, I can’t give investment advice. I’ve had a few emails from “Ask an Economist” readers who want to get my advice on the retirement strategy or portfolio. I’m no help on this.

There are two major reasons why I can’t give investment advice.

First, there’s probably liability associated with me using a large platform like FEE to give financial advice. I’m a professor, not a financial advisor. And economics, which is the study of exchange and the institutions under which exchange takes place, is not the same thing as finance, which deals more specifically with managing assets. The two are related but distinct.

Second, and more importantly, if there’s one thing economics has taught me about markets, it’s that I don’t have special knowledge about markets. I’ll elaborate on this point in my discussion of beta and its limitations.

Beta’s Limited Usefulness

As Bruce alluded, “beta” is an attempt to measure the volatility or riskiness of a stock. If a stock increases more quickly and decreases more quickly than the market as a whole, it’s considered volatile.

When the beta of a stock is equal to one, its volatility is on par with the market as a whole. But I’m a little skeptical of the value of beta in making investment decisions for a few reasons.

First, as Bruce mentioned, the volatility that beta measures doesn’t differentiate between increases and decreases in stock value. If the value of your stock fell at the same rate as the market as a whole, but it increased at a quicker rate, it would be measured as a more volatile beta.

So on this margin, I agree with Bruce. Beta lacks important information.

Measuring historical downside risk alone is probably a worthwhile endeavor, and my understanding is there are some attempted measures. But this weakness of beta is not my primary concern.

Why I Can’t Use Beta (or Anything) to Beat the Market

Even more importantly, my main issue with beta is that I’m skeptical of using historical information about an investment to try to make money.

Why?

Well, when investors buy and sell stocks, they do so on the basis of all available information. If an investor has information that the price of a stock will be rising, the investor will buy the stock and will drive up the price with the purchase.

Conversely, if an investor has information that the price of a stock will be falling, the investor can sell the stock (to take profits or minimize losses) or short the stock, driving down the price.

In other words, the price of a stock will reflect information relevant to its value immediately.

If prices reflect all available information, any price changes will be unpredictable in a literal sense. New information or inside information may allow you to get ahead of others, but once the information is priced in it becomes unpredictable again.

So, if you believe thousands of investors risking millions of dollars are wrong about their evaluation of the information, you can try to beat the market with your investment strategies. If you’re right consistently, you’ll make more money than the market.

I do not believe I know more than these career investors. Therefore I don’t pick stocks. I don’t try to beat the market.

At this point, some may point to investment strategies that, in the past, have generated returns higher than the market as a whole. But even if you beat the market once, other investors can learn from how you beat it, and that new information will be priced into the stock market.

If this happens, it will be impossible to systematically beat the market. Economists sometimes refer to this scenario as the efficient market hypothesis. If you disagree that markets are efficient in this sense, I invite you to beat them and make your millions.

None of this is to say concepts, like beta, which try to measure things like risk are useless. Risk considerations are important in investment and long term strategy. It only means the market has priced in the associated useful information already, so you won’t be able to use the information to make above normal returns.

Consider our previous example. Let’s say a certain stock’s price has historically fallen at the same rate as the market but grown twice as fast. Would knowing this and investing in this stock in the future generate returns which grow twice as fast? Probably not.

If investors noticed this trend (the stock growing faster than the rest of the market) and believed it would continue, the current stock price would already reflect that future growth. If career investors with millions on the line didn’t believe the trend would continue, I would tend to think there’s probably a good reason for the skepticism. In either case, historical volatility measures don’t provide future guidance.

I don’t deny some very smart people may be able to beat the market occasionally, but I don’t think I have any particular knowledge that allows me to do so.

So don’t ask for my advice! If I knew how to beat the market, I’d be rich already.

Unpredictable is Good

Some take this revelation that stock prices movements are unpredictable (or statistically random) as evidence that markets are bad. It seems like this is a very chaotic system!

However, the exact opposite is true. If market prices are unpredictable it’s because markets are successfully incorporating all relevant information about the value of a company’s capital. If market price changes were predictable, it would mean participants in markets are ignoring important information.

So,  economics probably won’t give you a leg up in investing. But, on the upside, learning more about the economy will help you appreciate the beauty of a system that contains more knowledge than any one person has the ability to access.