The Myth of Getting Rich Quick
We’ve all thought about it, the idea of getting rich quick. The idea of making lots of money in a short time period has long since haunted man, because, in economic terms, it makes no sense. People often use the outlet of financial markets to drive their idea of getting rich quick. The financial markets do for capital what other markets do for all everything; allocate it productively, yet imperfect way. Money flows in to the direction where it can get the highest return.
The idea of rich-quick schemes based of the financial methods don’t work because they violate basic economic principles; the same way eating a grapefruit and ice cream diet to lose weight goes against our knowledge of health and nutrition. When it comes to getting very good results in a short time span, we often throw our principles and logic out of the window and go against everything we know, when instead if took a step back and analyzed the situation, we realize that they simply don’t work.
Take a simple example, of trying to find a 4 bedroom, semi-detached house in Barnet. The houses listed for £600,000 need work done; others listed at £850,000 because they have extra amenities. During your house search, you come across a property priced at £300,000; and it is as good as any other house in the area, and fits your specification exactly. The estate agent assures you everything is legitimate and that you could sell this property in 3 months time for £700,000. Sure enough you buy the property and sell it on months later for a massive profit.
As you would expect, there are several things wrong with this story. 1st) Being how, if this house was worth £700,000, the seller is selling it at less than half the price. Was an estate agent/family member not willing to do 3 minutes of research to find out what other houses in the area are worth? Or does the seller just not want to maximize their utility? 2nd) If this house is such a bargain, where are the hundreds of other house-hunters? And why aren’t they leaping at the opportunity. And if they were, a bidding war would start, causing expansionary pressure and price, until it reached market value. 3rd) If the house is a such a good investment according to the agent, then why aren’t they buying it for themselves; and only settling for the 3% commission they earn.
In Layman’s terms, there is virtually no chance that you’ll find a 4 bed house in Barnet for £300,000. The reason being simple economics, you’re trying to maximize your utility, but so is everyone else. People are looking to make profitable investments and so no one is going to leave a £400,000 profit lying around.
The problem is that everyone else has access to the same information. This is the core of the efficient markets theory. The main idea of the theory consists of the fact that asset prices already reflect all available information. Thus, it is close to impossible to choose stocks that will outperform the market with any degree of consistency. Stock prices settle at a price which seems acceptable given what we know and accurately predict, and any changes in price will be in response to unexpected events, things we cannot predict or possibly know now.
For sure there are stocks that do better than others, and there are definitely signals to show how well a stock will do and by how much. But the reason why most professional stock pickers don’t beat the market average is because everyone has the same information and acts the same way. This relates back to the housing example and you can understand the idea of speculation in financial markets. Of course sometimes your stock will beat the market average, but other times it won’t, and so over time these two will cancel each other out and you’d be lucky to break average.
In economic terms, the idea behind getting rich quick, especially in the financial market, isn’t possible because you violate basic economic theory.