Business books:Burton Malkiel began telling investors that fund managers are idiots nearly 35 years ago. This, the ninth edition of his classic book, updates many of his earlier arguments and comes to the same conclusion: nobody can beat the market.
In many ways, this is a 415-page treatise about the virtues of "passive" (or index) investing. Accordingly, anybody who gives money to an "active" fund manager is irrational.
Like all massively overstated arguments, this one is based on a kernel of truth. Imagine there is but one (rather wealthy) owner of all the world's stock markets. By definition, our rich friend cannot beat the market - he is the market. At the very best, his portfolio can only go up or down exactly in line with the market.
If a second investor appears on the scene, we can imagine some trading of equities: we now have two people who own the entire market. But their combined return will never even equal the total market return: together, they can only earn the market return, less transaction costs (we always end up paying more than the asking price for stocks because of the fees that intermediaries charge).
Over any time period, if we add up the returns of everybody who invests in stocks, we find that they achieve what the overall market returned, less their trading costs. In aggregate, investors cannot equal the market, let alone beat it.
Why should we care about such artificial experiments? Surely we are just looking at averages here, and some people will be consistently above that average, while some are doomed forever to underperform?
Malkiel points us to the large body of (mostly US) evidence that suggests two-thirds of managers consistently do poorly. What about the one-third that must, therefore, do well? The good professor tells us that the real number is likely to be far less than this: the data, he asserts (but does not prove), is biased.
Malkiel is prepared to admit that there may be one or two managers who consistently do well. Here he relates the famous anecdote that implies good fund managers are really just successful tossers. Give the population of the US a coin and get them to call heads or tails. Roughly 150 million people will get it right. Get these success stories to toss again. This time, roughly 75 million people will be expected to make the correct call. Continue repeating the exercise until we are down to just a handful of people who have called heads or tails correctly. This small group will have had a remarkable run of success. The ultimate winner will be asked the secret of his tossing ability; he will say it's all in the fingers. But there is no skill involved: our punter is just a lucky tosser. This is how Malkiel views that small part of the fund management industry that has a long-term successful track record.
Malkiel is a devotee of the efficient markets theory of finance. This says that you can never consistently forecast a stock price. The underlying logic is simple: we never observe a €50 note lying in the street because somebody else will have picked it up first. Information that is important to stock prices is quickly, if not instantaneously, absorbed by the market - far too quickly for even the smartest investor to second-guess.
In the newer parts of the book, we sense that Malkiel has been put on the defensive by recent evidence which knocks the idea that the market is efficient. It's not just events such as the great technology bubble, but the growing body of literature around "behavioural finance", and the awarding of Nobel prizes to professors who have spent a lifetime studying the role of psychology - and irrational behaviour - in investing.
In their recent magnum opus, Triumph of the Optimists, Elroy Dimson, Paul Marsh and Mike Staunton of the London Business School display convincing evidence, similar to Malkiel's, that all investment fashions are built on sand. January effects, hemline investing, nifty 50, small companies rather than large, growth stocks: all these things, without exception, either fade or actually reverse. But the authors, like some other recent researchers, find evidence that value investing - buying stocks that have a specific definition of "cheapness" - does, over time, work. Malkiel reveals a sneaking regard for this kind of evidence, but pulls back from anything like a change of mind.
Warren Buffet has, with some justification, been called the world's greatest investor. He is very smart and is the epitome of a value-oriented fund manager. Closer to home, my predecessor at Bank of Ireland Asset Management, Chris Reilly, also has a global reputation as a formidable value manager. Both men have made money over several decades. But the key here is time: both of them are still making money because they understand that the only way to consistently beat the market is to take the long view. Anything can happen in the short term and it usually does. Anyone who makes money quickly is either lucky or doing something illegal.
Even Malkiel, I think, doesn't fully believe his own arguments. What he is really saying is that, to achieve consistent performance from stocks, you need to be very smart, very diligent and extremely patient.
But this is a well-written and often entertaining book. Once we get past the overstated arguments, we get a sensible "how to" guide for the individual investor. Funnily enough, it doesn't look too different from the methods used by the better fund managers.
Chris Johns is head of research and equity portfolio management at Bank of Ireland Asset Management
Warren Buffet (left)
has, with some justification, been
called the world's
greatest investor. He is very smart and is the epitome of a value-oriented fund manager.
But the key here is time: he is still making money because he understands that the only way to consistently beat
the market is to take
the long view.
A Random Walk
Down Wall Sreet
By Burton Malkiel
