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Beating the stock market over the long run is almost impossible, but you should try anyway.
The occasion to discuss how both of these statements can both be true is the 50th anniversary of the publication of “A Random Walk Down Wall Street.” In this book, which quickly became a classic, Burton Malkiel — a Princeton University economist — argued that stock price gyrations are random and therefore unpredictable. Some advisers will beat the market in the short-term, but hardly any will do so consistently over years.
The evidence in favor of Malkiel’s argument is overwhelming, as I have pointed out many times before. In a recent column, for example, I noted that the percentage of mutual funds able to beat the market over successive periods is close to what you’d expect from pure randomness.
The clear implication of Malkiel’s argument is that we should invest all of our stock-market money in a broad index fund and never trade. In fact, according to an under-appreciated study from two decades ago, this implication follows only if we are completely certain that no manager is able to beat the market over time.
As soon as we relax that belief by even the smallest amount, then according to this study it becomes irrational not to allocate a significant chunk of your portfolio to the managers who have beaten the market the most over the long term.
This study, entitled “Should investors avoid all actively managed mutual funds? A study in Bayesian performance evaluation,” appeared in the Journal of Finance in 2002. It was conducted by Klaas Baks of Emory University, Andrew Metrick of Yale, and Jessica Wachter of the Wharton School at the University of Pennsylvania. In an a recent interview, Baks told me that, notwithstanding two decades of additional research into the markets, their findings still stand.
Holding the ‘hot hands’
In the case of active investment managers, we’re focusing on our prior beliefs about whether market-beating ability exists and how we update those beliefs in the wake of additional years of those managers’ track records.
In their two-decade-ago academic study, the professors calculated how much of our equity portfolio should be allocated to active managers with the best long-term records. They in effect worked backwards, starting with a particular allocation to active management and then figuring out what our prior allocation would need to be in order to justify the new percentage.
They found that, in order to justify a zero allocation to active managers, our prior would have to be that market-beating ability doesn’t exist. Once we let go of that skepticism by just a tiny amount, it becomes rational to invest a good portion of our portfolio in those managers with the best long-term records.
How much must our belief shift? Imagine that your prior is that only one manager out of 10,000 has genuine market-beating ability. In that event, according to the professors, it becomes rational to allocate approximately 25% of your stock portfolio to following that manager. If you relax your prior more — and now suppose that one out of 1,000 has genuine market-beating ability — then you should allocate 50% to following the manager with the best long-term record.
The professors add that there is not enough data on active managers’ track records to differentiate between a prior that believes zero market-beating ability exists and another prior that believes such ability, while rare, nevertheless exists. Given this limited data, the choice between these two priors is unresolvable. “Zero investment in active managers cannot be justified solely on the basis of the statistical evidence,” the professors write.
So there you have it. Counterintuitive as it seems, it’s possible that it’s extremely difficult to beat the market while it’s rational to allocate a significant chunk of your portfolio to the best-performing active managers. I’m reminded of the famous line from author F. Scott Fitzgerald: “The test of a first-rate intelligence is the ability to hold two opposed ideas in the mind at the same time, and still retain the ability to function.”
Mark Hulbert is a regular contributor to MarketWatch. His Hulbert Ratings tracks investment newsletters that pay a flat fee to be audited. He can be reached at mark@hulbertratings.com
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