A Day Late and a Dollar Short

The financial media was all atwitter when Standard and Poor's downgraded the credit rating of nine European countries on Jan. 13, 2012. France and Austria lost their triple-A rating. CNBC's reaction was typical. It described this event as "a Black Friday 13th for the troubled single currency area."

The reaction was no less muted in Europe. A headline in the Guardian stated: "Eurozone in new crisis as ratings agency downgrades nine countries."

All over the world, analysts weighed in with their views of the dire consequences of this stunning news. Peter Apps, the political risk correspondent for Reuters told investors to "[D]itch the assumption developed economies are safe."

For investors, this reaction is a day late and a dollar short. As discussed by Jim Parker, vice president of Dimensional Fund Advisors, the liquid market for credit default swaps factored in the increased risk of the downgraded countries as early as November 2011. Credit default swaps are insurance against default by sovereign borrowers. The higher the premium for this insurance, the greater the perception of the market of the risk of default.

Parker observed that Germany, France and Austria all had a triple-A rating from Standard and Poors until Jan. 13, 2012. As far as the credit agency was concerned, these countries all had comparable risk of default. The perception of the market was quite different.

Parker noted that, as early as November 2011, the difference in the price of credit default swaps for France and Austria over Germany (which was not downgraded) increased significantly. The market was way ahead of the credit agency. It had already taken into account the increased credit risk of these countries. After the downgrade, the spread narrowed, indicating a perception by the market that the probability of default by France and Austria, compared to Germany, actually decreased.

The market for stocks and bonds takes into consideration all publicly available information and instantly incorporates that information into the price. This irrefutable fact has profound ramifications. Think about how most individual investors make investment decisions. They trade on their own using research tools provided by discount brokers (or worse, relying on technical charts with purported predictive value). They rely on analyst reports and the recommendations of their brokers or advisers. These "financial experts" are all too willing to pick the next "fund manager of the year," identify "mispriced" stocks, select high yielding bonds and predict the direction of the markets.

Relying on this advice, instead of looking at the market and recognizing the current price is a fair price, which reflects current and forecasted news, is the most fundamental error made by investors. The likelihood of identifying mispricings and profiting from them is 50 percent, before costs and taxes.

This is not an intelligent way to invest.

Dan Solin is a senior vice president of Index Funds Advisors. He is the New York Times bestselling author of The Smartest Investment Book You'll Ever Read, The Smartest 401(k) Book You'll Ever Read, The Smartest Retirement Book You'll Ever Read and The Smartest Portfolio You'll Ever Own. His new book, The Smartest Money Book You'll Ever Read, was published December 27, 2011.The views set forth in this blog are the opinions of the author alone and may not represent the views of any firm or entity with whom he is affiliated. The data, information, and content on this blog are for information, education, and non-commercial purposes only. Returns from index funds do not represent the performance of any investment advisory firm. The information on this blog does not involve the rendering of personalized investment advice and is limited to the dissemination of opinions on investing. No reader should construe these opinions as an offer of advisory services. Readers who require investment advice should retain the services of a competent investment professional. The information on this blog is not an offer to buy or sell, or a solicitation of any offer to buy or sell any securities or class of securities mentioned herein. Furthermore, the information on this blog should not be construed as an offer of advisory services. Please note that the author does not recommend specific securities nor is he responsible for comments made by persons posting on this blog.