A long-standing belief in the United States is that individuals get ahead through hard work and smarts. When it comes to the stock market, author Burton Malkiel believes these components alone are not enough.
In his book A Random Walk Down Wall Street, and again in a 2003 article titled “The Efficient Market Hypothesis and Its Critics”, from the Journal of Economic Perspectives, Malkiel tests strategies and portfolio managers to see if they can beat the stock market.
Malkiel’s conclusion is that “there is no dependable persistence in performance. During the 1970s, the top 20 mutual funds enjoyed almost double the performance of the index. During the 1980s, those same funds underperformed the index. Even the best performing funds of the 1980s underperformed during the 1990s.”
There are two major themes to be taken away. First, markets are not always right, but they are efficient. Second, there are several market inefficiencies, and funds have underperformed at some point or another.
Malkiel distinguishes between markets being “right” versus being efficient. Bubbles that form in the stock market or housing market are the only “exception”. There are periods of time when the market is under- or over-valued, but Malkiel argues that investors do not have a systematic way of gaining from this.
Specifically, Malkiel argues “even when we know after the fact that major errors were made, we know there were no arbitrage opportunities available to rational investors before the ‘bubble’ popped.”
Second, Malkiel reviewed the different strategies that research has found to have periods of gain over the market. These strategies included: low price-to-earnings, low price-to-dividends, low price-to-book value, momentum, reversion to the mean, seasonal and daily patterns and technical analysis.
The conclusion was that none of these strategies could be used consistently to gain above-average returns. Either the returns were no longer present in future years or the cost of trading to capture these returns reduced the benefit.
Items To Consider
Malkiel’s analysis is far-ranging and comprehensive. However, there were times that the research seemed short-sighted, particularly when the author suggests using long sets of data to corroborate ideas.
First, Malkiel cites Campbell and Shiller’s work from 1998 that indicates returns are dependent on initial valuations. However, Malkiel extends beyond their research to point out that in 1987 the stock market rose to the mid-20s and the average return over the next 10 years was 16.7%; a fantastic return. Through 2002, the return was 11.4%. Above average!
In addition, if we continue to monitor the performance of individuals who invested in June of 1987, we would see that the annualized return in March of 2009 was 4.2% and 6.8% through January 2013. This is exactly what the Leuthold Group research presented by Malkiel would have expected, so it would seem that Malkiel might have been too early in his assessment. Was he just benefitting from the market “bubble” that he himself identified in 1999?
There are two strategies often employed by financial advisors, which are the Dimensional Fund Advisors (DFA) mutual fund strategies and Dogs of the Dow. Malkiel cites two periods when these strategies did not work: 1993 through 1998 and 1995 through 1999, respectively. Considering that these are value-based strategies, can we assume that they underperformed due to the massive overconfidence of investors believing in the Internet?
Malkiel proposes that investors should follow an index approach. He rationally argues the benefits of each strategy in favor of a passive investment approach.
Because market valuations are often incorrect, Malkiel concludes in his research that investors are unable to prosper from any predictable pattern.