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The market is not perfectly efficient, but you still can't beat it

MoneyWatch blog wars give prominent experts a chance to debate big issues related to the economy, the stock market, and personal finance. In this round, Robert G. Hagstrom and Charles D. Ellis face off on whether you should invest with active managers who try to beat the market, or stick to low-cost index funds that deliver market returns.

I'm delighted to engage with Bob Hagstrom, a good man I'm glad to know pretty well although we've only met once. We know each other from reading each other's books over quite a few years. From reading, it's clear to me that Bob is savvy, well-informed, and articulate. We usually agree - but not always. So I'll try to focus on our few differences:

  • The relevant question Bob and I should address is not whether markets are or are not "efficient." "Efficiency" is a matter of degree.
  • Is the stock market perfectly efficient? Is all information instantly captured in market prices?
  • No. (I'm tempted to say, "Of course not.")

Let's modify the question and make it more realistic.

Q: Is the stock market so efficient at incorporating all information that no investor can operate profitably?

A: No - again Bob cites Warren Buffett and Bill Miller and I agree on both. And over the long term, the American Funds managed by Capital Group Companies has repetitively outperformed. But these are exceptions. "Exceptions that prove the Rule."

Q: The key question is whether the market is sufficiently efficient that the great majority of investors will not be able to outperform the market? Ah, there's the rub!

A: Yes! The stock market is clearly too efficient for most of us to do better. As Bob notes, in a typical decade, 60% of actively managed funds fell short of the market. And that's before taxes!

Extend to 20 years and the record is worse: 80% of actively managed funds underperform - again, that's before the cost of taxes.

Worse, the reported data on fund returns is overstated - or upwardly biased - because the worst funds are quietly closed and buried - and withdrawn from the records.

Q: Can investors in mutual funds improve on the dour data by dumping duds and moving to winners?

A: Painfully, the hard-hearted record documents that individual investors hurt themselves - badly - by changing funds. On average, they destroy over 25% of the returns earned by their funds by changing. We don't have to be experts in behavioral economics to recognize that investors sell funds that have done poorly and buy funds that have done well - all too often way too late in both cases.

Sadly, investors who rely on performance records are relying on useless data. Divide all mutual funds into deciles of past performance and study which deciles of past performance are any help in predicting future performance. Here's what you'll find out: Only one decile has any usefulness in predicting the future by studying the past. No, not the best decile. Only the worst decile predicts: Bad investors tend to stay bad.

One more piece of evidence: Over time, compare the relatively few funds that do better than the market with those that do worse and you'll find many more funds do worse and they do worse by more than the few winners do better. That hurts.

So let's reframe the relevant question: Are markets so efficient that sensible investors should recognize - and take advantage of the knowledge - that the market is not perfectly efficient but it sure is so very efficient that normal investors will not improve their investment results by trying to beat the market?

Yes! Today's market, dominated by expert professionals, is so nearly efficient that almost all investors are not able to do better than the market. So they should focus attention on not doing worse. And that's why indexing is so sensible and successful. As the familiar saying has it, "If you can't beat 'em, join 'em!"

Even most professional investors can't and don't beat the market. So why waste our time trying to outsmart a market that incorporates all the best thinking and information of hundreds of thousands of smart, hardworking investment professionals all over the world?

The simple summary is this: If you would like to outperform 80% of all other investors, buy and hold low-cost index funds.

In his words - It's a small book with a big mission: Give regular people the important fact-based advice they really need - and no more - to do right for themselves with their 401(k) plans (and their other investments). Burt Malkiel and I condense 100 years - 52 for Burt; 48 for me - of truly fortunate experience as investors, advisers to investing institutions, and teachers at Yale, Harvard, and Princeton. Our goal for Elements of Investing: Provide the most useful help for the most people who need it.

Charles Ellis serves as a consultant on investing to large institutional investors, government organizations, and wealthy families, as a director of the Vanguard group of mutual funds and several business ventures, and as Managing Partner of a pro bono partnership of Harvard Business School classmates that supports entrepreneurial, change-oriented ventures in education, particularly those focused on children born into tough circumstances. He has taught at Harvard, Yale, and served 20 years on the faculty at Princeton. Ellis is author, with Burton Malkiel, of Elements of Investing.

Robert G. Hagstrom is a senior vice president at Legg Mason Capital Management and portfolio manager of the Legg Mason Growth Trust mutual fund and he manages the growth equity strategy for the company's institutional clients. Previously, Robert served as president and chief investment officer of Legg Mason Focus Capital. Prior to working with Focus Capital, he was a Principal at investment counseling firm Lloyd, Leith and Sawin. Robert has also been a portfolio manager with First Fidelity Bank a Financial Advisor for Legg Mason Wood Walker, Inc. Robert earned a B.A. and M.A. from Villanova University. He is the author of six books, including The Warren Buffett Way: Investment Strategies of the World's Greatest Investor.

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