Ed Mamula.com

 

I realized that I’ve been taking some ignorant swings at “Random Walk” and the Efficient Market Hypothesis.  I hadn’t really read anything related to random-walk since Economics 101.  This realization, coupled with the fact that I literally live in the shadow of a wonderful public library that I have NEVER used, led me to take the short, direct walk to the library to get the book and review it.

All in all, the book is a good read and a valuable read in the sense that stock investors who take its recommendations to heart are far less likely to shoot themselves in the foot by overtrading, chasing performance, etc.

The basic premise of the book is that price movements in the stock market resemble a random walk, and that past price movements are not predictive of future price movements.  The book does make passing mention of a LONG TERM UP TREND in equity prices roughly equivalent to the long run rate of earnings growth, but rather curtly declares that transaction costs are prohibitively high, and therefore, short-term trend trading is not superior to a buy and hold approach.  In fact, it categorically goes through most widely followed methods of stock picking and explains why these are inferior to index investing.

Get it?  Two things : Future stock prices cannot be predicted, and nothing beats buying and holding a diversified portfolio that is primarily made up of US stock index funds.

Here are some important limitations to consider, however.

The conclusions about efficient pricing and long term upward bias apply to the STOCK MARKET ONLY.  Furthermore, while the book explains why fundamental and technical analysis “do not work”, it pre-supposes that an inability to predict the future movements of stock prices necessarily means that one should not be able to outperform the market over a long period of time.  Keep in mind that the book had already acknowledged the inconvenient trend phenomenon but managed to “normalize” it away.

My own evolution as a trader has taken me away from active stock investing.  In fact, the relatively small percentage of my assets that are currently held in stock funds are actually invested in index funds.  Why?  The risk-reward relationship for successful stock picking is relatively small due to the high costs and/or inavailability of high degrees of leverage.  I personally find my skill set more suited for forex trading, but this is by no means a recommendation that everyone run out and start changing their dollars for euros and pounds and whatnot.  Forex trading is purely speculative, and speculation and investing are really two entirely different animals.  Month after month, my forex trading results are convincing me that speculative, short term trend following in the forex market can and does produce returns that are not only outstanding, but also uncorrelated to the returns in my stock portfolio.  This is diversification at its best. 

Despite my rather facetious rant against index funds in a prior post, the vast majority of us will be investing in stock funds via tax advantaged accounts like IRAs and 401k’s…for this purpose, Random Walk’s advice is practical, easy to implement, and perhaps the best way to get rich slowly and enjoy a financially free future.
 

Time and again, investors are fed statistics on how few actively managed mutual funds outperform the S&P 500 index (or some other relevant benchmark).  A casual glance around the ‘Net this evening revealed to me that 80% of actively managed funds do not beat the S&P 500 index.  This bit of knowledge is usually followed by all of the benefits of owning index funds, such as low costs, “good” long term returns, a strategy that is easy to automate and guarantees average returns, etc.  The message is that it is so hard to beat the average that we should simply buy the index, and strive to be average.  This type of advice is never given in other areas.  “Jimmy, it’s tough to get straight A’s, so do as little work as possible and be happy with a C- average”.

Let me be the first to say just how easy it is to actively manage your own account and do WORSE than average.  It’s so quick and easy to set up an online trading account and start buying things left and right without any real strategy.  The trader who does this sure better hope the market really is random!  I suppose that this would be the typical life cycle of a risk-taking investor:  The young maverick boldly charges into the market.  He thinks that high risk equals high returns.  On cue, the market moves in his favor, and he becomes absolutely sure that trading is fun, easy, and highly profitable!  The maverick trader will inevitably get stuck in a losing position and have no pre-determined exit strategy.  At this point, his choices are to hold on and hope that the position will recover, or sell it out at a loss and “wise up” to the fact that he cannot beat the market.  His experiences with active management and personal financial loss with likely lead him to invest in index funds, where at least he can do no worse than the average.

But wait!  You saw the title of this article…and it’s true!  100% of S&P 500 index funds underperform the S&P 500 index.  Their costs may be low, but they are not zero.  In this way, index fund investors guarantee themselves a slightly below average return because they are afraid that any attempt to do better will land them a failing grade.  This does NOT mean that actively managed mutual funds are necessarily a better choice.  Actively managed funds do charge higher fees, and give their clients’ money a little bit of a deeper hole that it has to dig itself out of before it can even think about outperforming the S&P.  And indeed, just as there are many average investors, there must be many average money managers, all of which are willing to extract fees from investors and deliver a return just close enough to the average that their investors do not cash in their shares.

I believe that the average mutual fund manager’s primary motivation is to perform well enough to keep his job for another year.  To do this, he must deliver returns that are at least similar to his peers.  This tendency to fixate on the averages results in something I like to call “average cling”.  If the average money manager is simply going to invest in a basket of stocks that will perform close to average by design, what is he doing to deserve the management fee?  Average cling is like taking an exam and knowing what the curve will be ahead of time, then deciding to stick as close to it as possible so as not to stand out on the downside and get kicked out of the class.

Perhaps the best way to achieve above average results inside of a mutual fund is to invest with a manager that completely disregards the averages and strives for absolute return.  Such managers are rare, but certainly not unheard of.

Granted, the strategies above are aimed at passive investors; that is, those of us who do not want to spend our time picking stocks or other assets to include in a portfolio.  There are certainly higher return avenues available to investors who are willing to do their own work, but understand that consistently outperforming the market requires a love of trading and investing.  Just focusing on returns will not be sufficient motivation to put in the necessary work.  The necessary work is considerable, and it might just outlast your attention span.  

Index funds are STILL a good choice for the average, risk-averse, passive investor. It’s okay to be average. Just don’t let the establishment fool you into thinking that it’s impossible to break the curve.

(This article is part of the 87th edition of the Carnival of
Personal Finance…check it out!)