(MoneyWatch) There are two theories about investing. The conventional wisdom is that the markets are inefficient -- there are smart people, who, by their diligent efforts, can uncover which stocks are mispriced (under or overvalued) by the market. This is called the art of stock selection. The belief is also that smart people can also time the market, getting in ahead of the bull emerging into the arena and out ahead of the bear emerging from its hibernation. This is called the art of market timing. Together they make up the art of active management. Thus, the focus of believers in active management is on managing returns.
The problem with trying to manage returns is that there's an overwhelming body of evidence (as presented in "The Quest for Alpha") that trying to manage returns is the loser's game. While it's possible to win, the odds of doing so are so poor that it's not prudent to try. Trying to manage returns is focusing on trying to control the things we have no control over since so much of market returns are determined by surprises. In addition, those focusing on trying to manage returns often make decisions based on emotions -- greed and envy in bull markets and fear and panic in bear markets. And losing control of emotions is what caused Kramer, Jerry and Elaine, to lose their bet -- they were no longer masters of their domain.
The other theory is that the markets are highly, if not perfectly, efficient -- the price of a security is the best estimate of the correct price -- otherwise the market would quote a different price. If markets are efficient, efforts to outperform are highly unlikely to prove productive after accounting for the expenses of the effort. Those who believe that markets are efficient focus their efforts not on managing returns, which cannot be controlled, but on the only things we actually can control:
- The total amount of risk we take
- Diversifying the risks we decide to take as much as possible
- Keeping costs low
- Keeping tax efficiency high
- Adhering to your investment plan, not allowing your emotions to control your decisions
By focusing on the things you actually can control you become the master of your investment domain.
Image courtesy of Flickr user 401(K) 2013.