tween the buying and the selling price of shares. Second, investors pay
management fees (and possibly sales, or “load,” fees) to the organizations
and individuals that sell these funds. Finally, managers are often compet-
ing with other managers with equal or superior skills at choosing stocks.
As noted earlier, it is a mathematical impossibility for everyone to do bet-
ter than the market—for every dollar that outperforms the average, some
other investor’s dollar must underperform the average.A LITTLE LEARNING IS A DANGEROUS THING
It is interesting that an investor who has some knowledge of the princi-
ples of equity valuations often performs worse than someone with no
knowledge who decides to index his portfolio. For example, take the
novice—an investor who is just learning about stock valuation. This is
the investor to whom most of the books entitled How to Beat the Market
are sold. A novice might note that the stock has just reported very good
earnings but its price is not rising as much as he believes is justified by
this good news and so he buys the stock.
Yet informed investors know that special circumstances caused the
earnings to increase and that these circumstances will not likely be re-
peated in the future. Informed investors are therefore more than happy
to sell the stock to novices, realizing that the rise in the price of the stock
is not justified. Informed investors make a return on their special knowl-
edge. They make their return from novices who believe they have found
a bargain. Uninformed indexed investors, who do not even know what
the earnings of the company are, often do better than the investor who is
just beginning to learn about equities.
The saying “a little learning is a dangerous thing” proves itself to be
quite apt in financial markets. Many seeming anomalies or discrepancies
in the prices of stocks (or most other financial assets, for that matter) are
due to the trading of informed investors with special information that is
not easily processed by others. When a stock looks too cheap or too dear,
the easy explanation—that emotional or ignorant traders have incor-
rectly priced the stock—is usually wrong. Most often there is a good rea-
son why stocks are priced as they are. This is why beginners who buy
individual stocks on the basis of their own research often do quite badly.PROFITING FROM INFORMED TRADING
As novices become more informed, they will no doubt find some stocks
that are genuinely undervalued or overvalued. Trading these stocks willCHAPTER 20 Fund Performance, Indexing, and Beating the Market 349