John Maynard Keynes was one of the most influential economists in history. In the first half of the 20th century, Keynes explored ideas related to the economic balance between supply and demand.
Many of his ideas were based on the concept that economic demand is influenced by a number of fluid factors and may be volatile and unpredictable in the short term.
His theories on macroeconomics are often described as Keynesian economics. At the heart of Keynesian economics is the idea of short-term economic inefficiency or irrationality. In fact, market irrationality is the subject of a quote that is most-often attributed to Keynes: “The market can stay irrational longer than you can stay solvent.”
The exact wording of the quote and whether or not Keynes actually said it have been contested. But the idea of temporary imbalances in the market is the singular justification for active investing.
Active investors believe that they can hand-select underpriced or overpriced stocks and create a portfolio of stocks that will perform better than the overall market. For this strategy to work consistently, active investors must be able to identify and capitalize on market inefficiencies.
For active investors, timing is everything. Unfortunately, active investors must go beyond simply identifying market inefficiencies. They must also get the timing right as well. Even if an investor recognizes that a stock or group of stocks is underpriced, it doesn’t necessarily mean that buying the stock will be profitable in a year or two or three.
“In 1997, many people pointed out how crazy tech company valuations were – and they rose for another two years,” says Brad McMillan, chief investment officer for Commonwealth Financial Network.
“In 2005, houses were widely noted to be too expensive – and they rose for another two years,” he says. “When you invest, you have to get both the facts and the timing right because even if your facts are right, the timing can kill you.”
Another way to look at the Keynes quote is that financial markets tend to have a great deal of short-term momentum, and betting on a shift in momentum is often a losing battle.
“Keynes was referring to the tendency for market trends to persist for a long time, long enough for anyone fighting the trend to lose their money,” says Jurrien Timmer, director of global macro for Fidelity Investments. “The message is that it is important to have an objective understanding of market dynamics.”
An alternative theory. But there is also an entire class of economists and investors who reject the idea that financial markets are inefficient or irrational. In fact, the efficient market hypothesis, developed by Eugene Fama in the 1960s, is an economic theory that states that assets are always accurately priced based on all the information available to the market at any given time.
Efficient market hypothesis subscribers believe that wild swings in asset prices during times such as the tech bubble of the late 1990s, or the housing bubble of 2006 and 2007 are simply reflections of changes in the information available to investors.
“Active investors still exist because they do not understand the Nobel Prize-winning efficient market hypothesis. The wisdom of the crowd will always exceed that of an individual,” says Mark Hebner, CEO of wealth advisory firm Index Fund Advisors. “Today’s technology allows that information to spread faster, and investors have the ability to trade faster, making markets even more efficient than they were in 1965 when Fama proposed the idea.”
Do market rationality and efficiency matter? Fortunately, diversified, long-term investorsdon’t need to settle the age-old debate of whether or not the stock market can be inefficient at times. They also don’t need to worry about timing those inefficiencies correctly. Even if Keynes is correct and markets can be irrational for extended periods of time, they eventually correct themselves when the bubble bursts or the recession comes to an end. In that respect, the only people who should be worried about irrationality in the markets are short-term investors and speculators trading stock options and other assets that have expiration dates.
Recessions and bubbles come…
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