Argument

Muting the Noise

Muting the Noise

As markets around the world rise and fall, a clarion call goes out from economists to small investors: Buy index funds, and trade as little as you can. This is good advice, but the financial industry and the media have coincided in a way that encourages people to ignore it.

The titans of finance have never had such a great friend as today’s financial media. Together, they have formed a symbiotic complex that has great benefits for both sides — but potentially enormous costs for small investors.

When moving their savings into the financial markets, small investors have a few basic choices. Namely, they can actively trade securities via a brokerage firm, either with a live person or by themselves online; entrust the active trading to a professional by investing in a managed fund; or buy an index fund whose value simply tracks the ups and downs of the market as a whole. It turns out that the choice between these three options matters — a lot — and the media may be pushing investors toward bad decisions.

For years, economists have known that index funds yield higher returns on average than both managed funds and active trading by individual investors. This is in part because trading by individual investors is costly; the more a small investor trades, the more commissions the investor must pay, and the lower the overall return will be.

Few individual investors and fund managers will be as successful in predicting corporate profits as professional researchers and analysts are at investment banks. Someone whose work week is devoted to knowing every twist and turn of the semiconductor industry will probably have a better sense of Intel’s share price than someone who juggles dozens of stocks or trades for a few minutes a day in front of a home computer.

As a result, the traders who act on the analysts’ information have an enormous advantage. Any small investors who trade with these professionals are likely to be on the losing side. There may be a few good deals floating around in mutual funds because of supply-and-demand effects — occasionally, as money flows out of the market, fund managers can find bargains for their investors  – but small investors will not always be able to take advantage.

If investing through index funds yields superior returns, why don’t more people do it? One reason is the increasing accessibility of active trading. There were about 4 million online brokerage accounts open in the United States in 1997, and by 2012 there were ten times as many, including about 17 million active traders. This is a global industry, too, with almost as many online accounts in Hong Kong and China, and perhaps 10 million more in Europe.

Commissions are lower online, and there’s a certain allure to being able to put one’s own beliefs about the economy into action. But those beliefs are shaped by another industry — the financial media – that is hardly acting in the best interest of investors.

Every day, websites and television channels offer a deluge of information that is supposedly intended to help investors make better decisions. Yet most investors lack the tools to evaluate the information and the people who supply it. In fact, most of the information is probably useless.

By the time Bloomberg, CNBC, or Xinhua features a talking head to discuss a company’s prospects, the reported information is likely to be priced into that company’s shares. If the purported expert genuinely had new information, sharing it for free in front of the cameras would be much less lucrative than actually trading on it. So investors who rely on these talking heads and act on their information, thinking it to be new, will inevitably become saps for professional traders. The only time professional traders will tune in is when a company’s executives, or someone else who can deeply affect a company, show up to make news themselves. For legal reasons, that almost never happens.

Moreover, professional traders want individual investors to react to the talking heads. Every time an individual investor trades, the market price of a share moves a little bit, which opens up opportunities for arbitrage. Without the deluge of information causing millions of reactions in the market every day, there would be many fewer chances for the professionals to make money. A market where prices hardly ever change is as worthless to professional traders as it is to brokerage firms that rely on commissions. Both need investors to react to news and make share prices move — the more often the better.

How the media outlets operate is also problematic. Rarely do they track the accuracy of their pundits’ predictions for the benefit of the investing public; good looks and juicy sound bites are their preferred currencies. Each news item receives play determined in part by the volume of news that day, not entirely by its own significance to a company’s shares. Every editor has to fill the content hole and can’t just have the anchor say, “No important news today — see you tomorrow!”

Fortunately for them, a constant drumbeat of supposedly important and impartial data releases resounds almost every day from a variety of government and private sources. Once again, however, investors don’t necessarily have the means to weigh these data and determine the implications for the stocks in their portfolios.

For instance, two of the most popular items for media outlets are indices of consumer sentiment and purchasing managers’ activities. If people are confident in their own incomes, and if managers are buying a lot of inputs, then presumably the economy will grow and corporate profits will rise. But the relationship between these variables is far from obvious, as the below chart shows.

The two indices above may well have some predictive value for corporate profits, which may in turn affect share prices over and above the usual forces of supply and demand. Yet how many small investors can figure out exactly what that value is and how it applies to the particular shares in their portfolios? Without this knowledge, the data — as well as discussions of the data in the financial media — are just useless noise.

With time, individual investors may learn that index funds save them money and yield higher returns. But people take lessons from their own experience, and not necessarily from the overall performance of the market. Those who happen to do well through active trading — in other words, the lucky ones — will conclude that they’ve figured out how to beat the market. When mutual fund managers outperform the index funds — often, again, because of luck — money will keep pouring into their coffers.

To be sure, online accounts may raise investors’ returns slightly by cutting commissions for trades that otherwise would have gone through a live broker. The industry also makes a variety of saving instruments more accessible to the public, which can help with long-term financial planning. And financial media outlets across the globe, despite the yammering of their talking heads, might be helping some investors to learn how the economy works. But by encouraging people to invest actively rather than passively, they may all be doing more harm than good.