Originally published in the New York Times
IF you’ve been wondering whether it’s possible to regularly beat the stock market averages — a natural question with the market at an all-time high — you didn’t get any guidance from the Nobel Prize committee this year: Two of the winning economists disagree on that perennial issue.
In one corner is Robert Shiller, the Yale economist who argues that markets (and by implication, share prices) are often irrational and therefore beatable. He famously predicted the bubble in technology stocks in the late 1990s.
In the other corner is Eugene Fama, the father of the view that markets are efficient and that they are always processing all available information. Mr. Fama’s followers believe that investors who try to beat the averages will inevitably fail. (There was also a third winner, Lars Peter Hansen.)
As someone whose professional life centers on evaluating investment managers, I come down emphatically with Mr. Shiller.
I get Mr. Fama’s theory, but the evidence points decidedly in the opposite direction. I have met many investors who have consistently outperformed the market. Take, for example, the world’s most famous — and most successful, if judged by personal net worth — investor, Warren Buffett. Mr. Buffett began an investment partnership in 1956 and, over the next 12 years, achieved a 29.5 percent compound return, mainly by buying carefully selected stocks and then almost always holding them for a long period.
In comparison, the Dow Jones industrial average rose by 7.4 percent per year during the same period.
Then, in 1965, Mr. Buffett took control of a small Massachusetts textile manufacturer and through a combination of buying stocks and, later, buying entire companies, achieved a 19.7 percent annual increase in Berkshire Hathaway’s stock price while the average was increasing by 9.4 percent.
Not surprisingly, Mr. Buffett’s views are clear: “I’d be a bum on the street with a tin cup if the markets were always efficient.”
A significant number of endowments and foundations have also succeeded in posting stellar results. Since 1993, Yale’s endowment appreciated by 13.5 percent per year, while the S.&P. rose by 8.6 percent.
To be sure, some of this outperformance results from Yale’s perspicacity in identifying new areas with promise, as it did more than two decades ago by being among the first large institutions to move into private equity.
But even within traditional investment areas, like public equities, Yale and many of its peers have surpassed the indexes, largely by allocating funds to savvy outside investment managers.
Over the past 20 years, for example, Harvard’s public stock portfolios returned close to 11 percent per year, compared with about 9 percent for the indexes.
While selecting good managers or attractive stocks has led to superior returns for the savvy, trying to quickly time the market has been less successful.
Sophisticated investors have learned that even when they are convinced that an overall market is expensive or cheap, markets can indeed be irrational and predicting the timing of the inevitable correction can be challenging.
As the economist John Maynard Keynes (who outperformed the averages in his own investing) purportedly said, markets can remain irrational longer than an investor can remain solvent.
Among the raps against investment managers are the high fees some charge, particularly hedge fund managers. But returns are always measured after taking fees into account.
Of course, for every investor who is beating the market, another must be falling short. That’s certainly true, and among the losers are mutual funds that cater to small, individual investors who do not generally have access to top managers.
According to a recent study by the research firm Dalbar, typical equity mutual fund returns over the last 20 years were about half (4.25 percent) of market gains (8.2 percent).
That suggests that individuals should not park their money in actively managed mutual funds, let alone pick stocks or try to time the market.
Yet so many do, often on the basis of a cable television show recommendation or just their own intuition. But most of us would not repair our home’s electrical system or deliver our own babies without proper training.
Fortunately, Mr. Fama’s work on efficient markets did a favor for the small investor: it spawned low-cost index funds that replicate market averages.
That’s where the nonexpert should park his money. Of course, decisions have to be made about how much cash to hold and whether to own some bonds.
By all means, make those decisions. But as the commercials say, when it comes to active investing, “don’t try this at home.”
