Is the stock market efficient, and does it matter?
Most investors buy and sell stocks (or invest in actively managed mutual funds), under the premise that markets are not efficient, and that securities are mispriced. They attempt to either buy companies that are worth more than today’s price, or sell companies that are worth less than today’s price.
To carry this question to its logical conclusion, those who feel markets are not efficient invest with the ultimate goal of outperforming, or “beating” the returns generated by the stock market average, which is simply a collective valuation of all the publicly traded companies.
Is the stock market efficient? This long-simmering debate between academicians and Wall Street stockpicker-types will never be resolved, and in the end, it doesn’t really matter.
A more relevant question investors should address in regards to this debate is whether or not one can, with any confidence, embrace a strategy that takes advantage of market inefficiencies and security mispricing, to outperform the stock market average over an extended period of time.
Let’s take a closer look at the data surrounding market efficiencies, and investors’ results from trying to exploit the mispricing of securities. According to Standard & Poor’s, for the five-year period ending March 31, 2007, the following percentage of actively managed equity funds underperformed their respective benchmarks
Large Cap Funds 72.22 percent
Mid Cap Funds 77.38 percent
Small Cap funds 77.67 percent
The above data suggests that, while markets might not be completely efficient, the fact that such a small percentage of professional stock pickers outperform a benchmark indicate the difficulty of consistently identifying mispriced securities.
Unfortunately, the above statistics reveal only part of the investment story for investors who try to “beat the market,” with actively managed mutual funds.
Dalbar, a Boston based company that compares investor behavior with investment results, recently completed their 2008 research paper titled, “Qauntatative Analysis of Investor Behavior.” In its annual report, the study found that for the twenty year period ending December 31, 2007 where the S&P 500 index generated an annualized return of 11.82 percent, the average equity mutual fund investor’s return was a paltry 4.48 percent, resulting largely from a fund holding period of only 3.14 years.
Dalbar’s study confirms that selling underperforming funds in search of top performing funds wreaks havoc on long term returns, and is a dilemma faced by many investors who hang their hopes on a star stockpicker.
A good example of this quandary has surfaced recently in the performance of Legg Mason’s Value Trust fund (LMVRX), managed by Wall Street’s widely worshipped stockpicker, Bill Miller. For the 15 year period ending 2005, this actively managed mutual fund handily outperformed the S&P 500 Index each year, by an impressive average margin of 4 percentage points a year.
Since then however, the returns haven’t been so rosy, with the Legg Mason Value Trust lagging its benchmark over the past 28 months by a 30 percent total return. Investors are now faced with the decision whether to stay invested in Miller’s underperforming fund, or switch allegiance to another professional stockpicker.
For portfolio dollars that are allocated to common stocks, investing in the stock market is all about maximizing one’s return potential over an extended period of time that includes both up and down markets. A simple and successful way to achieve this investment objective, that also puts the pursuit of performance in its proper perspective, is through globally diversified, low-cost, portfolio of index funds.
One way to invest in the stock market is through a “total stock market” index fund. However, there are potential benefits of taking this concept to another level by identifying and investing in different components of the market that include value and small dimensions. This is a topic that will be covered in a future blog post, so stay tuned.