There’s been a lot of buzz around whether anyone can beat the market, courtesy of the Nobel Prize committee.
The Swedish Academy has stirred all this up by giving the economics award this year to Eugene Fama. The University of Chicago professor shares the prize with Lars Peter Hansen and Robert Shiller.
“Stirred up” because Fama is best known for the idea of market efficiency, a notion often oversimplified to mean that nobody can get an edge in investing because prices are always accurate, all the time.
Fama and his colleague Kenneth French are pilloried for this by active fund managers, and you can imagine why. The entire business model of Wall Street runs on the notion that anybody can beat the market if they try.
A more accurate way to think about Fama and French’s contribution to the discussion is not that any given stock is correctly priced, but that your chances of guessing its current price are not better than the chances of the market itself.
Consider Francis Galton’s county fair guessing-game regarding the weight of an ox. Averaging all of the guesses by fairgoers turned out to be amazingly accurate. The average was better than any single player’s estimate and beat the estimates of cattle experts.
Not convinced? Then how about the incident of the lost U.S. submarine, documented by James Surowiecki in his book “The Wisdom of Crowds.”
In 1968, the United States lost a submarine, the Scorpion, in the North Atlantic. The Navy had no way to find it in a 20-square mile area under thousands of feet of ocean, so they turned to experts in a variety of disciplines — math, salvage, submarine design — and asked them to come up with their best guess.
By combining the guesses using an algorithm they pinpointed the sub’s resting place, missing by just 220 yards.
Stock picking did work once, and it worked for a long time. The investors of the 1920s had a huge advantage, or disadvantage, depending on how connected they were to company insiders. That imbalance helped feed the Great Crash.
Even into the 1980s and 1990s you could arguably say that some people knew more than others. Today, massive computer trading programs and the wealth of public data and discussion have erased uncertainty.
Like Galton’s ox and the missing sub, there now are just too many “guesses” in play to ignore the power of the averages that they imply.
Research has concluded exactly this point: In 1990, it was fairly common to find funds that offered “alpha,” even if only by luck. Nearly 15% of funds did so. By 2006 the number had fallen to 0.6%.
“Although the number of actively managed funds dramatically increases over this period, skilled managers (those capable of picking stocks well enough, over the long-run, to overcome their trading costs and expenses) have become exceptionally rare,” the authors wrote.
How can you avoid the “beat the market” trap? Stay away from “hot” managers, “hot” socks, and “hot” sectors, advises Darren Wu at WiseBread. The answer, he concludes, is to stick to the basics: asset allocation, diversification and rebalancing.