It has been 30 years since financial economists first theorized that beating the market is almost impossible. Since then, many studies and experiments have confirmed this hypothesis. And yet, every day, millions of investors—egged on by a Wall Street publicity machine eager to encourage frequent trading—believe they can pick winning investments.
It doesn’t make sense, argues Burton G. Malkiel, the Princeton University finance professor who helped develop the hypothesis that investment markets are efficient and hard to beat. If the markets can be beaten, “then professional investors, who are richly incentivized to outperform passive investors, should be able to produce excess returns,” he writes. “For me, the strongest evidence suggesting that markets are generally quite efficient is that professional investors do not beat the market.”
Malkiel coined the term “Random Walk” 30 years ago to describe the hypothesis that the stock market is efficient. By efficient market he meant one where stock prices adjust almost immediately to new information. “If new information develops randomly, then so will stock prices, making the stock market unpredictable apart from its long-run uptrend,” he writes in The Financial Review.
Despite many confirmations of that view over the years, some analysts have suggested that stock prices are predictable based on certain variables. If that were true, Malkiel writes, then the records of professional investors would reveal that they would be able to use those variables to predict markets and earn higher returns. “If prices were often irrational and if market returns were as predictable as some critics believe, then surely actively managed investment funds should be able to outdistance a passive index fund.” It doesn’t happen, he writes. Over the 34 years from 1970 through 2003, virtually all of the 139 U.S. stock funds in existence for the entire period were beaten by the Standard & Poor’s 500 Stocks Index, he said. Although five of those funds managed to beat the index by at least two percentage points, it would have been extremely hard to identify them in advance, he argues.
“There is not sufficient persistence in performance to be able to choose winning managers by an examination of their past records,” he writes. For instance, the 10 best funds of the 1960s were poor performers in the 1970s, while the 10 best funds of the 1970s lagged behind the market during the 1980s, and so on. Recent market results dramatically illustrate this difficulty. There were 20 stock funds from 1996 through 1999 that handily beat the market, earning an average of 50% more than the S&P 500 during the four-year period. “The portfolio managers of these funds were written up in the financial press as investment geniuses,” Malkiel notes. However, during the succeeding four years, this group of funds had dismal results, on average generating “negative returns almost three times worse than the market as a whole.”
Malkiel also notes that mutual fund rating services give investors little clue as to what to do. Morningstar Inc.’s well-known five-star rating service cannot predict winning funds, he says. Its highest rated funds typically underperform the market.
So should an investor throw up his hands and give up? Not at all, Malkiel says. If you can’t beat the market, it is better to join it by owning a low-cost fund indexed to the market, he recommends. “The best investment advice for both individual and institutional equity investors is to buy a low-cost broad-based index fund that holds all the stocks comprising the market portfolio,” Malkiel concludes.
