ARGUMENT

Muting the Noise

How the media make us all bad investors.

BY DANIEL ALTMAN

FEBRUARY 19, 2014

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 todays 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.
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 Intels 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 dont 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 manyonline accounts in

Hong Kong and China, and perhaps 10 million more in Europe.
Commissions are lower online, and theres a certain allure to being able to put
ones 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
companys prospects, the reported information is likely to be priced into that
companys 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
companys 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
theaccuracy 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 companys shares. Every editor has to fill the content
hole and cant 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 dont 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
theyve 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.
http://foreignpolicy.com/2014/02/19/muting-the-noise/