Last week, I encouraged you to reflect on the first crucial question for building your Investment Policy Statement (IPS): Are you a short-term or long-term investor? Were you able to give it some thought? What conclusion did you come to? I'd love to hear about it! Feel free to reply to this email and share your insights. This week, we’ll explore another key question for your IPS: What is your investment philosophy when it comes to the nature of financial markets? In simple terms, do you believe financial markets are efficient or inefficient? This is an important question that shapes how you approach investing. And don’t worry—sometimes a straightforward perspective is all a retail investor needs!
It all starts with the Efficient Market Hypothesis (EMH): - Efficient means the market is quick to adjust to new information.
- Market refers to stock markets, like the New York Stock Exchange.
- Hypothesis means it's a theory or idea. In an Efficient Market:
- Prices change fast when new information comes out (like company earnings or news).
- Investors can’t consistently predict these changes and make profits from them because everything known is already factored into the price. There are three versions of EMH:
1. Weak form: Prices reflect past stock prices and volumes, so you can't use that info alone to predict future prices.
2. Semi-strong form: Prices reflect all publicly available information, so even analyzing company reports or news won't give you an edge.
3. Strong form: Prices reflect all information, both public and private (even insider info), making it impossible for anyone to gain an advantage.
Depending on whether or not you believe in the efficient market hypothesis and its forms, you could be a passive or active investor. Passive Investing: - Goal: Match the market, not beat it.
- How it works: Instead of picking individual stocks, you invest in a whole market or index (like the S&P 500) through index funds or ETFs. You’re not trying to find the best-performing stocks.
- Belief: The market is efficient (like the Efficient Market Hypothesis suggests), so trying to pick winners is a waste of time. Over the long term, markets tend to go up, so by holding a broad portfolio, you’ll grow your money steadily.
- Cost: Lower fees because there’s less buying, selling, and research involved.
- Example: Buying a fund that tracks the entire stock market ( an index fund or an ETF) Active Investing:
- Goal: Beat the market by picking specific stocks that will perform better than average.
- How it works: You (or a fund manager) actively research and trade stocks, trying to find undervalued stocks to buy and overvalued ones to sell.
- Belief: The market is not fully efficient, so if you’re smart or have better information, you can find opportunities that others miss and make more money.
- Cost: Higher fees because of the research and frequent trading.
- Example: A mutual fund manager who buys and sells stocks regularly to outperform the market. Summary:
- Passive investing aims to ride the market’s overall growth with less work and cost.
- Active investing tries to beat the market through research and stock-picking, but at a higher cost.
Which type of investor do you think you are? | 
