You Can Beat the Market; You Probably Shouldn’t

There is this feeling you get reading market hacks.

You look around, wide eyed . . . this trick made people money . . . but only I took the time to find out? I’m surrounded by simpletons listening to murder podcasts with no idea capitalism has a cheat code. Next year, we vacation at Sandals!

The number of get-rich trading hacks people have “discovered” this way defies calculation. The hot stock tip has a very long history. I’ve found references at least back to the 1600s. Things got more complicated over time, but the basic ideas are the same: if you know what they know, you can beat the system. There were simply too many schemes to try yourself, which was a shame, because I wanted to try them all.

Of all the silly stock strategies I attempted, none was more fun or frustrating than “The Cramer Bounce.”¹ In a 2005 research paper, finance professors found a glitch in the matrix. CNBC’s hit show Mad Money, hosted by former hedge fund manager Jim Cramer, was affecting the market for blips of time. Cramer is boisterous and ballsy. He screams. He rants. He occasionally throws things. He also regularly discusses a single stock in detail, followed by recommending that viewers buy, sell, or wait. The professors found that when: a) Cramer spent long segments on a single stock, b) the recommendation was “Buy,” and c) the ratings for the show were high, the stock rose the next day. Critically, the price bump almost always went away. It was usually gone, and often went down in value, within fifty days.

Voilà! I’d found the recipe. If I watched Mad Money each night, I could hone in on the target. Then, I made sure no huge sporting events were on, my proxy for ratings. Now I could profit off the poor suckers watching at home by shorting the stock. This was going to be great!

It was terrible. I lost money, which wasn’t the worst part. First, to short stocks I had to get a margin account (a brokerage agreeing that you can borrow money to buy stocks). Sounds easy. But they wanted me to have the cash in the account where I planned to borrow. To borrow $10,000, I had to have $5,000. I didn’t have $5,000. Could they do a thousand? No, the minimum was $2,000 and then I could borrow $4,000. So, after much paperwork and some hemming and hawing answering questions about being an “experienced investor,” I managed to get my margin account.

When you short a stock, you borrow someone else’s. Why? To sell it to another person. Why? Because you think they’re an idiot. This fool is paying too much, and soon the price will go down. When that happens (if it happens), you’ll buy it back cheaper than you sold it. Then just give the stock back to its original owner. This is like if you borrowed my power tool, sold it on Ebay, then bought the exact model cheaper on sale and returned it to me. I still have a DeWalt brushless drill, and you made a profit: selling for $100 and buying back for $95, you kept the $5 difference. It is buying something and selling it for a profit, but in reverse. Now do that, with borrowed money, times 1,000 shares, and you just paid the rent.

It sounds vexingly complex, but it’s not. You pay for something you never owned, with money you did not have, selling to someone you’ll never meet, because you plan to buy it back from someone else for less. Make sense? Of course not. It’s ridiculous, but I didn’t make the rules.

Now that I had my account, I could settle in five nights a week at six o’clock in the evening. This got old, fast. I had a wife. I had a new child. Neither wanted a balding man in a tie setting off sell sirens at high decibels. In the name of science, they would have to persevere. It took a while for the stars to align: long segment, buy siren, no Monday Night Football. Straight to the website I went, carefully hitting the buttons to borrow someone’s shares to sell to a bored retiree.

A great stock market commentator once noted that, as with losing your virginity, there were some things you just had to feel to understand. “Like all of life’s rich emotional experiences, the full flavor of losing important money cannot be conveyed by literature.”² Correct. Watching your borrowed money ebb and flow for days on end teaches you a lot about yourself. In my adult life, I have vomited just four times. Twice I was sick. Once I was drunk. The fourth time I was short a midwestern utility company borrowed against my infant’s college fund.

I soldiered on. There were wins and there were losses. Eventually I shut the margin account down and settled for just buying the stock at the opening bell (going long) and selling quickly a few days later. The only people that made money in this whole gambit worked for E*TRADE, who kept my low-but-not-nonexistent transaction fees. When it was over, my actual trades had won. The professors were right, and I beat the market. Net of fees, however, I had lost about $400.

The worst part of all this was, while Cramer was yelling at me like I was a child, my daughter was learning to walk. The idea itself wasn’t wrong, and to some extent, the moves I made were right. But there is nothing like hearing “come quick she’s doing it!” from downstairs to erase all your gains.

* * *

Yes, you can beat the market. But beating the market is a bad idea.

Sophisticated people these days disagree. Any money book, whether by journalists or gurus, will assure you that “study after study” proves no one can beat the market. Buckle up and buy an index fund. Since that is extremely boring advice, they will offer lots of inspiring stories and graphs explaining how to stop splurging on Starbucks and slow-go your way to a not horrific retirement.

Their skepticism is warranted. Alfred Cowles³ wrote a 1920s investment newsletter, quit when he realized he had no idea why prices rose, spent the rest of his life testing the financial predictions of others, and concluded by 1932 that a randomly drawn deck of cards got better returns than professionals.

The next year, the cleverly titled How to Lose Your Money Prudently⁴ told the possibly fictitious story of an investment banker who, struggling with a pen, splattered ink all over the newspaper’s stock section. Intrigued by the randomness of which stocks got hit (and quite possibly made up to explain Cowles’s recently published academic paper), the banker proceeded to discover his stock-picking division had underperformed this Rorschach test for a decade.

In 1973, Burton Malkiel took the urban legend to another level by asserting that a blindfolded monkey throwing darts could out-pick the pros in his A Random Walk Down Wall Street.⁵ The idea stuck. The first time I heard it, a novice investor assured me it had involved a live monkey, but no one could admit this because of PETA.

In 1988, the staff of The Wall Street Journal began a fourteen-year semi-annual stock throwing competition.⁶ Sans monkey, Malkiel threw the first dart. Since then, multiple research studies reported randomized selections beat the pros, including another round of WSJ reporters beating billionaire hedge fund managers in 2019, and mutual fund conference speakers in 2022. For the single year the picks were made, journalists beat tycoons.

Informed skepticism has a name, and it isn’t the Monkey’s Dart Board Theorem. The Efficient Market Hypothesis (EMH) is the foundation of nearly all investment theory today. The idea is simple: financial prices are products of groupthink. The prices of almond futures, tech stocks, or government bonds reflect all the information about lactose intolerance, AI, and politicians available right now. The little price movements around it are just the noise of an insurance company buying new assets here, a retiree selling some there. Because everything everyone knows is already in the price, there is no way to guess tomorrow’s. Prices shift only when we learn something new.

Stock prices follow a “random walk.” They don’t go anywhere in particular, and you never know from one moment to the next if they will step forward or back. Crucially, what a price just did has no relationship to what it is about to do. Asset prices aren’t drunks. They are meth addicts staring off with no sense of direction or time. There is no yesterday. No tomorrow. Just right now.

There is a lot more math and a Nobel Prize behind it, but that is the gist. The idea also wasn’t original to the economists who invented it, though the equations were. The oldest investment diary in existence, of middle-class English investor Samuel Jeake, noted much the same thing in 1699. “For telling when ’tis a good time to purchase, that’s past my skill or anybody else’s.”⁷ Now we had the math to prove that there was no way to “win” in the market unless you have information others do not have. And if you have information others don’t, a phenomenon called “insider trading,” you go directly to jail without passing Go.

* * *

EMH seemed to be proven right time and again, especially when it wasn’t. When everyday people tried to invest like the best, they ended up like the rest.

This was sweetly displayed when a group of little old ladies became famous for their investment club’s 24 percent annualized returns. Beginning in 1983, the Beardstown Ladies of Illinois pooled funds in the Lutheran church basement, selected stocks with a ten-ingredient “recipe,” and used midwestern values to kick the S&P 500’s fanny. Their book and DVD sold nearly a million copies and made the Beardstown Ladies investment superstars.⁸ Investment clubs became extremely popular.⁹ By 1998 there were 37,000 groups nationwide:¹⁰ teachers clubs, kids clubs, ladies clubs, and gay clubs.

Clubs underperformed significantly. One study found groups lagged the market by a massive 20 percent annualized.¹¹ The Beardstown Ladies, it turns out, were good at potlucks but not with accounting. When audited, their actual returns were 9 percent over a decade when the S&P returned 14 percent. They had great fellowship, though.¹²

There you go. The market is efficient, far too efficient for you to know something others don’t. Those who try, fail. There isn’t anything to do but learn to love randomness.

I didn’t have access to a monkey, but I did have a toddler. Before you do what I did, and ask a child to point at your Apple Stocks app to re-create the pick-em contest, know this: over the full 14 years after The Wall Street Journal began their experiments, the darts averaged a 3.5 percent return.

The pros, meanwhile, were up double digits.¹³

It turns out, not all walks are random. And some people do, indeed, beat the market.

* * *

The Efficient Market Hypothesis has two problems. The first is that asset prices don’t always do what it says they should. The second is that people regularly make money in ways it says they shouldn’t. That’s quite a pickle for a theory everyone keeps using.

According to EMH, prices move randomly and their volatility (not the direction of the step, but how jerky it is) stays within a certain range. Think of this like our drug addict on the street. You don’t know which way they will go, but you do know the area they’re likely to stay in. In practice, this means that most steps of our ne’er-do-well (market prices) should land pretty close to where they are right now. Of all the steps they could possibly take, even a series of steps, none launches them out of the city.¹⁴

That is the problem. Not often, but often enough, prices move wildly as if they are chased by demons. The first scholars to turn EMH into a workable model won a Nobel Prize one year and lost $4 billion the next. How? The Asian financial crisis and subsequent Russian government debt default were, per theory, a once every 6 trillion year phenomenon,¹⁵ but somehow appeared at the same moment as the Seinfeld finale. Both experiences disappointed.

Rare events appeared more than expected. When they did, the market sobered up into a world-class Olympic pole vaulter. Sometimes things went crashing through the floor. There have been five black-swan events (things happening today that yesterday’s prices said weren’t possible) in my lifetime alone: 1987, 1998, 2001, 2008, and 2020. That is just to the downside. There were also wild swings upward. A portfolio missing the best ten days of the past 112 years¹⁶ would have lost out on two-thirds of all stock market gains. Theory didn’t predict the wild swings up, either.

This matters. The farther a stock got away from its EMH cage, the greater the price effect of each step. Beyond a certain point, these weren’t jumps, but superhero leaps—a multiplying force—so that losses and gains took on comic-book absurdity. Each step did affect the next. In these moments, the impossible happened. Meth Head became the world’s most unlikely super soldier, leaping into tomorrow and destroying portfolios.

Efficient Market Hypothesizers took this all in stride. Rare events? Maybe not so rare. Wild swings? It takes time for investors to sift the data. Markets may not be perfectly efficient, but they are efficient enough.¹⁷ Doubt only confirmed the faith for most believers.

* * *

The heretics weren’t having it.

Two sects broke away from the EMH orthodoxy. The first were value investors, who argued the real trick was to buy future income when it went on sale. They are the Nordstrom Rack of personal finance. Why pay full price for designer names when you can own them for less?

The founding prophet of value investing was Benjamin Graham.¹⁸ Graham thought prices came from “Mr. Market,” a manic depressive who partied for long periods and then took downers. It was best to sell when he was high and buy when he was depressed. Graham regularly beat the market and later published his seminal book, The Intelligent Investor, in 1949. His protégé, Warren Buffett, became possibly the greatest investor of all time, beating the overall stock market by two to one over a long career. He is so famous that you already knew that.

If markets were truly efficient, then the success of Graham, Buffett, and their lesser-known acolytes shouldn’t have been possible. After all, they had the same information as everyone else.

The other sect of contrarians were a motley crew falling under the umbrella of “technical analysis.” These included everyone from commodities billionaire Paul Tudor Jones to stay-at-home day traders like Roaring Kitty, the investor embodying the Covid-era meme stock movement.

An army of divinity seekers searched the ticker-tape scrolls, creating increasingly complex price movement charts. Technical analysts thus became known as chartists.¹⁹ The reason stocks fluctuated, they told Graham’s cheapskates, was not the businesses but the buyers. As more buyers chased after a stock, the price went up. When the buyers went away, so did value. The art was to use charts to see where buyers were going, then get ahead of them.

Charts had bottoms (when everyone was done selling), heads (when everyone stopped buying), shoulders (which helped you find the head), resistance (found from the shoulders), and support (which held up the bottom). Games of heads, shoulders, knees, and toes became the hottest way to search for stock market miracles.

Scoffed at as pseudoscience by opponents, the method became the stuff of finance courses²⁰ by 1948. “Support levels” and “resistance levels” are the daily talk of analysts the world over, driving strategies that beat The Wall Street Journal’s writers and, if the lore is true, a blindfolded primate.

Astoundingly, for some investors, it worked. In fact, academic papers consistently found price strategies to exploit. Not only that, but these methods continued to be profitable,²¹ though usually only half as much, years after the findings were published.

If you are wondering why academics would publish their findings rather than run straight to their trading accounts, you don’t know many academics. Professors are a risk-averse people. We talk grandly and act smally. Our lust is for tenure and prestige. Printing one’s study gets a modest but lifelong payout in job security and invitations to speak at conferences of real risk takers as their distinguished guest. The big winners, meanwhile, rarely share their secrets.

* * *

How did people do what theory said they couldn’t? What was their secret? Can you use it to impress the people you went to high school with?

Start here. The market may or may not be efficient, but it is never fair.

First, the big winners are rarely passive. Warren Buffett personally interviewed the CEOs of prospective companies, very often demanding a seat on the board. He actively mentored their executives. You may get a notification to vote your 200 shares in Microsoft’s annual meeting, but there are 7 billion others. You don’t get to walk into corporate and speak your mind.

Buffett also bought his investments with debt. So do most major investors. Buffett’s leverage has been estimated at around 1.7 to 1.²² For every dollar Buffett invested, he borrowed another dollar and seventy cents and invested that, too. Nearly every large investor I’ve studied did the same, regardless of industry or strategy.

Debt is a big part of this story. Great investors do revert to the mean. They win some, they lose some. Warren Buffett’s worst investment was buying that New England textile firm early in his career, which he was about to sell until their CEO pissed him off. He invested millions of more dollars, and nearly the only thing he got out of the deal was the company’s name, Berkshire Hathaway.²³ If he lost so much money losing his temper, why is he Warren Buffett?

The one piece of wisdom that transcends all the rabbis of anti-efficient market radicalism is this: cut your losses quickly. This lesson occurs in every major value investor’s book and biography, but is also the central theme of a multi-volume set of interviews with the most successful chart-following technical analysts.²⁴ As it turns out, they are all getting rich the same way. When they hit predefined loss points, the greatest traders sell immediately. When they win, their wins can run for decades. Magnified by the borrowed money, reversion to the mean doesn’t mean very much. They can be wrong half of the time losing a million here, a million there, but be right and make $100 million in one go. Most studies of reversion to the mean don’t account for this tendency to admit defeat quickly while leveraging success.

Finally, most big market beaters grab things others can’t reach. This is what I mean by the market is not fair. Most big winners buy things you can’t buy because you don’t have enough money or know the right people—usually both.

After fourteen chapters detailing how to buy undervalued stocks with a margin of safety, Lord of Value Ben Graham proceeded to explain that this is not how he made his own fortune. He expressed “grave reservations” about everyday investors’ prospects for succeeding doing what he was telling them to do, since it isn’t what he principally did. Graham’s incredible returns came from buying liquidated companies at auction, complex arbitrages and hedges, and the acquisition of bargain stock issues not available to the general public. “We hesitate to prescribe our own diet for any large number of intelligent investors,” he said in a book literally titled The Intelligent Investor.

David Swensen,²⁵ possibly the greatest institutional investor not named Warren Buffett, employed a small platoon of Yale-educated finance grads to vet ideas. His biggest score was buying millions of acres of timber land when that sounded crazy. When you’re handling billions of dollars, opportunities come looking for you. As I write this, investors who spent as little as six cents on the dollar buying claims for Sam Bankman-Fried’s collapsed crypto exchange, FTX, are about to be repaid more than the original claims were worth.²⁶ For some, they will 15x their money. It turns out, one of the things the wunderkind did with all his illegal transfers was buy large shares of the AI firm behind ChatGPT, which are now very valuable.

Why didn’t you buy them? Because they weren’t for sale anywhere you could look. By the time this made the news, the great returns were gone. The same happened with the farmland Bill Gates bought in 2013. These investors did something you couldn’t do before you thought to do it, and once you’ve heard about it, all the real money was made.