The Middle of the Road: A Personal Viewpoint

The Middle of the Road: A Personal Viewpoint

Let’s first briefly recap the diametrically opposed viewpoints about the functioning of the stock market. The view of most investment managers is that professionals certainly outperform all amateur and casual investors in managing money. Much of the academic community, on the other hand, believes that professionally managed investment portfolios of stocks with equivalent risk characteristics. Random walkers claim that the stock market adjusts so quickly and perfectly to new information that amateurs buying at current prices can do just as well as the pros. Thus the value of professional investment advice is nil – at least insofar as it concerns choosing a stock portfolio.

I walk a middle road. I believe that investors might reconsider their faith in professional advisers, but I am not as ready as many of my academic colleagues to damn the entire field. I believe that investors might reconsider their faith in professional advisers, but I am not as ready as many of my academic colleagues to damn the entire field. While While it is abundantly clear that the pros do not consistently beat the averages, I must admit that there are exceptions to the rule of the efficient market. Well, a few. While the preponderance of statistical evidence supports the view that market efficiency is high, some gremlins are luring about that harry the efficient-market theory and make it impossible for anyone to state that the theory is conclusively demonstrated Finding inconsistencies in the efficient-market theory became such a cottage industry during the late 1980s, that I will devote a few word to an analysis of the market anomalies that have been uncovered.

Moreover, I worry about accepting all the tenets of the efficient-market theory, in part because the theory rests on several fragile assumptions. The first is that perfect pricing exists. As the quote from Paul Samuelson indicates, the theory holds that, at any time, stocks sell at the best estimates of their intrinsic values. Thus, uninformed investors buying at the existing prices are really getting full value for their money, whatever securities they purchase.

The secret of getting ahead is getting started (Mark Twain). Photo by Elena

This line of reasoning is uncomfortably close to that of the “greater-fool” theory. We have seen ample evidence that stocks sometimes do not sell on the basis of anyone’s estimate of value (as hard as this is to measure) – that purchasers are often swept up in waves of frenzy. The market pros were largely responsible for several speculative waves from the 1960s through the 1980s. The existence of these broader influences on market prices at least raises the possibility that investors may not want to accept the current tableau of market prices as being the best reflection of intrinsic values.

Another fragile assumption is that news travels instantaneously. I doubt that there will ever be a time when all useful inside information is immediately disclosed to everybody. Indeed, even if it can be argued that all relevant nes for tha major stocks followed by institutional investors is quickly reflected in their prices, it may well be that this not the case for all the thousands of small companies that are not closely followed by the pros. Moreover, the efficient-market theory implies that no one possesses monopolistic power over the market and that stock recommendations based on unfounded beliefs do not lead to large buying. But brokerage firms specializing in research services to institutions wield considerable power in the market and can direct tremendous money flows in and out of stocks. In this environment it is quite possible that erroneous beliefs about a stock by some professionals can for a considerable time be self-fulfilling.

Finally, there is the enormous difficulty of translating known information about a stock into an estimate of true value. We have seen that the major determinants of a stock’s value concern the extent and duration of its growth path far into the future. Estimating this is extraordinary difficult, and there is considerable scope for an individual with superior intellect and judgment to turn in a superior performance.

But while I believe in the possibility of superior professional investment performance, I must emphasize that the evidence we have thus far does not support the view that such competence exists; and while I may be excommunicated from some academic sects because of my only lukewarm endorsement of the semi-strong and particularly the strong form of the efficient-market theory, I make no effort to disguise my heresy in the financial church. It is clear that if there are exceptional financial managers, they are very rare. This a fact of life with which both individual and institutional investors have to deal.

Burton G. Malkiel. A Random Walk Down Wall Street, including a life-cycle guide to personal investing. First edition, 1973, by W.W. Norton and company, Inc.