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The price already knows everything
The efficient market idea
That is a theoretical concept and not literally true, but it explains a trap. Liking a Tesla and expecting the company to do well is no edge, because everyone knows it is a pretty good company making pretty good cars that sell well. All of that is already in the price.
Discounted future cash flows
What a buyer gets is discounted future cash flows. Companies earn profits, and buying a stock buys those expected profits at a discount, which is called the discount rate. Riskier stocks carry higher discount rates, and holding the asset pays that rate as a return.
Managers who beat markets
The record of professional money managers fits. Most of those trying to beat the market by picking stocks and timing it do not, and the managers who beat it over one period tend not to beat it in the next. Before or after fees the distribution looks similar, though it is worse after fees. If a drop were certain, prices would fall today, so declines come from new information that nobody expected.
Where did the efficient market idea come from?
The efficient market hypothesis is most closely linked to Eugene Fama of the University of Chicago, whose 1970 paper in the Journal of Finance reviewed the evidence for it. Fama shared the 2013 Nobel Prize in economics with Robert Shiller and Lars Peter Hansen. Fama and Shiller reached very different conclusions about whether prices can stray from fundamentals.
Why do winning fund managers rarely repeat?
Mark Carhart's 1997 study of mutual funds in the Journal of Finance found little evidence that past winners kept winning once costs and momentum effects were accounted for. S&P Dow Jones Indices publishes a persistence scorecard that finds few top-quartile funds stay in the top quartile over the following years. Most of the persistence that did show up came from funds with the lowest expenses and from poor performers that kept performing poorly.
Why do riskier stocks need higher discount rates?
Investors can diversify away risk specific to one company, so they demand extra return only for risk that remains across the whole market. In a 1992 paper, Eugene Fama and Kenneth French found that stocks of smaller companies and companies with low prices relative to book value had earned higher average returns. Their 1993 three-factor model adds size and value to the market factor.
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