An important function of competitive markets is driving prices to equilibrium. This refers to a state where market prices balance the demand from both buyers and sellers. Every trader who thinks the price of a security is high is offset by one who thinks the price is low. So, they agree to transact, voluntarily, at the current price. If there is insufficient interest in buying, the price must fall until a new equilibrium is reached.
If this sounds too abstract, sports betting markets may be a useful parallel. When an undefeated team squares off against a winless team, few expect the latter to emerge victorious. The only way to induce gamblers to bet on the weaker squad is to lower the“price.” This is accomplished by a point spread indicating essentially how much the underdog can lose by and still be considered a winner for betting purposes.
The largest point spread in NFL history came in 2013 when the Denver Broncos played the Jacksonville Jaguars. The gulf in quality between the teams was so great that nobody would bet on the moribund Jaguars until you spotted them 28 free points. Anything short of that and the supply would exceed the demand for the Jaguars.
In case you’re wondering, the Broncos won that 2013 contest by “only” 16 points. So, the winning bet was the Jaguars. An underdog winning against the spread is far from an aberration – historically, they do about half the time. And that’s the key takeaway from market equilibrium. Winning against the market becomes a coin-flip because the quality of assets has already been handicapped in the prices. In other words, knowing a good company from a bad one won’t help you pick better stocks than the market. You’ve got to have more insight into those companies than other investors, and that’s a tall order in competitive markets.
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Against the backdrop of heightened political uncertainty, potential trade wars, and lower consumer sentiment, investors may have concerns about whether the US could tip into a recession. The National Bureau of Economic Research identifies recessions using backward-looking data, so we won’t know we’re in recession until after it’s begun.
Luckily for investors, markets are forward-looking and generally react before we see slower economic growth show up in the macroeconomic data. This also means that expected stock returns are positive, even when the economic outlook is weak. This is borne out in the historical data. One dollar invested at the start of a recession saw positive returns after three years in 12 out of 13 past recessions. The average of the three-year returns after the start of a recession was 43.2%, which is nearly identical to the 41.8% average return of all three-year periods from 1947 to 2024.
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Stock market declines over a few days or months may lead investors to anticipate a down year. But the US stock market has had positive annual returns in many years despite some notable dips.
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When markets feel as shaky as they do now in the US, it is normal to ask: Is this time different?
After all, the S&P 500 Index is down some 4% already this year and there is considerable economic uncertainty. But anxious investors today should consider where the market was five years ago, and how well those who tuned out the noise performed.
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David Booth went to graduate school because he wanted to get a Ph.D. and become a professor.
What he learned was how to make a fortune as an entirely new kind of investor.
When he was a student at the University of Chicago a half-century ago, his teachers were future Nobel Prize winners whose curious ideas about financial markets would transform the way people think about money. Their lectures were rough drafts of the papers that showed how ordinary investors who barely touched their boring portfolios could outperform professional managers and famed stock pickers after fees and expenses. And that innovative and counterintuitive research on market efficiency would one day fuel the rise of passive investing.
It would also change Booth’s life.
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