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Efficiency of Financial Markets
The idea that markets efficiently process information is nothing new. The concept of market efficiency has been rigorously discussed and researched in academic circles for over a century. In the late 1800’s, it was observed that when “shares become publicly known in an open market, the value which they acquire may be regarded as the judgment of the best intelligence among them.”6 Some years later, a young French mathematician named Louis Bachelier wrote his dissertation on the behavior of stock markets. After studying the French capital markets around the turn of the century, he concluded that “past, present and even discounted future events are reflected in market price.”7 In the 1960’s, a group of college professors and financial economists developed what later became known as the Efficient Market Hypothesis. The idea assumes that information is so rapidly reflected in the market that no single investor can consistently know more about stock prices than the market as a whole knows. The implication is not that markets always price assets perfectly, but rather they do so well enough that it’s exceedingly difficult for any one investor to systematically beat the market.
Any investor willing and able to use this knowledge is the beneficiary of a reasonably efficient market. In such an environment, any investor buying a portfolio of index funds8 should obtain a rate of return as generous as that achieved by the experts, a point stressed by Princeton finance professor Burton Malkiel.9 If information is already reflected in security prices, professional money managers should not be able to consistently earn above-average returns by analyzing financial information. Some will earn high returns just by chance. While this might surprise some readers (and irritate most, if not all, active fund managers) the market’s history of delivering With many things, “average” is mediocre; with decision-making, the average is often excellence. superior long-term returns is well documented in numerous academic studies. Despite these studies’ conclusions, investors have not been able to resist the temptation of trying to beat the market. Close to 90% of all dollars invested in the capital markets are “actively managed” with the goal of exploiting whatever small and fleeting inefficiencies might exist.
The Evidence
If markets were inefficient, that is to say if frequent and sufficient mispricing existed and could be systematically exploited, we would expect to find evidence that some skillful investors could consistently “beat the market.” Little, if any, evidence exists. The world’s most sophisticated investors—the professional mutual fund managers, large corporate pension plans and savvy hedge fund managers—certainly haven’t provided it. On the contrary, their performance strongly suggests that, like Treynor’s jelly bean experiment and Google’s web searches, the collective wisdom of the market knows best:
- Through January 2008, the Vanguard S&P 500 Index Fund—which makes no attempt to pick attractive over unattractive stocks—outperformed 78% of all diversified U.S. large company stock funds over 15 years.10
- Professional managers of bonds fare even worse, with 80% of funds underperforming a broad fixed income index over the past fifteen years.11
- A recent survey of hedge funds found the average fund delivered returns of 8.8% from 1995-2003, a period during which the S&P 500 Index returned 12.4 percent.12
- From 1988-2004, a simple portfolio comprised of 60% S&P 500 Index and 40% Lehman Brothers Aggregate Bond Index outperformed 75% of the nation’s largest corporate pension plans, despite those plans’ resources to hire the world’s brightest investment minds.13
Fooled by Chance
In spite of the odds stacked against them, however, a few managers—just like the small handful of students in the bean-counting experiments—will outperform the market in any given period. Some will even manage to do it over a seemingly long-enough period to convince investors of their skill. But is it truly skill, or is it simply luck? It’s hard to know. After all, if we fill a stadium with people flipping coins and excuse them one-by-one after a flip of “heads,” someone will remain as the only person to record a very long string of successive “tails.” If we shove a microphone in that person’s face, she might even indulge us with her “secret” to flipping tails, after which the coin-flipping world will crown her the Supreme Flipper-of-Tails. Just as it is exceedingly difficult to identify who this coin-flipper will be in advance, it is hard to know who will be next year’s winning investment manager. The fact is, someone will be that winning manager. Thanks, of course, to their employer’s marketing budgets, it will be easy to identify them after the fact.
Two well known standouts of the last thirty years are Peter Lynch of Fidelity and Legg Mason’s Bill Miller. Peter Lynch is widely considered one of the greatest investment managers of all time. During his thirteen year tenure managing the Fidelity Magellan mutual fund, he outperformed the annual return of the S&P 500 Index eleven times. Lynch became the subject of numerous articles, appeared on the cover of magazines and even wrote his own book, which eventually became a best-seller. When he retired as manager of the fund in 1990 and became a director of Fidelity, one of his primary roles was to find his successor—the next Peter Lynch. Apparently, his good fortune picking stocks did not extend to picking stock-pickers: since 1990, four different managers have taken the helm at Magellan and, collectively, they have delivered returns which have lagged the S&P 500 Index by about 1% per year. If Peter Lynch can’t find the manager who can outperform the market, what chance does the typical investor have?
More recently, Bill Miller attracted attention after amassing a streak of besting the S&P 500 for a truly impressive 15 consecutive years.14 Like a lot of streaks, the longer Miller’s extended the more attention it received and the more dollars flowed into his fund (unsurprisingly, major inflows did not begin until 1997, the seventh year of the streak15). In 2006, however, the streak came to a crashing halt as the Legg Mason Value Trust gained only 5.8%, trailing the S&P 500 by 10%. 2007 was not much kinder: for the full year the fund posted a negative return of 6.7%, lagging the market by over 12%. Investors attracted by the “sure bet” implied by Miller’s past record must surely be disappointed.
When it comes to the fleeting nature of outperformance in investing, Bill Miller and Fidelity Magellan are not alone in the investment game. Consider the results of all the best-performing equity mutual funds over the ten years from 1983 to 1993: of the top twenty funds in that period, sixteen failed to even match the market return in the subsequent decade—that’s an 80% failure rate.16 Over the long-run, it seems the world’s smartest investors are not beating the market, the market is beating them.17
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