Among financial scholars, it’s an article of faith that the vast majority of investors can’t beat the stock market regularly. According to the traditional academic literature, if you invest long enough, spread your money around in a diversified portfolio, and hang on through thick and thin, then you are nearly certain to end up doing about the same as the averages – an annual return, before taxes and expenses, of about 10 percent. Not much more, not much less.
Consider mutual funds, which are run by highly paid experts backed by large research staffs. Such funds have a huge incentive to beat the market, since standout funds pull more cash from investors and thus more fee income for managers. Yet academic studies show that, on average, mutual funds actually do a little worse than the market as a whole. As a result, the smartest strategy would seem to be owning low-cost index funds, such as Vanguard Index 500 (VFINX), which mimic nearly the entire market.
Yes, a few investors do beat the market. Some get lucky. Others get higher rewards because they take higher risks. And a tiny minority of investors may simply be geniuses like Warren Buffett, who calculates in the latest annual report that his company, Berkshire Hathaway Inc. (BRK), has increased its book value at an average rate of 22 percent a year since 1965.
The reason most investors neither consistently beat the market nor consistently underperform it is explained by what economists call the “efficient-market hypothesis,” developed by Eugene Fama of the University of Chicago nearly 40 years ago. The idea is that the price of a stock today reflects all the public information that can be known about a company, the market and the economic environment. In other words, today’s market price is the “right” price, and tomorrow’s price (since it is based on unknowable information) cannot be predicted today. From today’s perspective, future prices move in a “random walk.”
If the EMH is correct, then it’s folly for investors to believe they are smart enough to buy stocks when they are “cheap.” It would seem that, with fast Internet connections, a robust business press, and many more buyers and sellers, stocks are, if anything, even more efficient than they were when Fama invented the notion.
Still, the EMH remains controversial, and a new working paper – “Can Individual Investors Beat the Market?“, by Joshua D. Coval of the Harvard Business School, David A. Hirshleifer of Ohio State University and Tyler G. Shumway of the University of Michigan – raises a powerful challenge. The researchers found that a significant minority of investors can beat the market, not through luck but through what appear to be superior stock-picking skills.
Coval and his colleagues started with the records of 110,000 accounts at an undisclosed discount brokerage firm. They zeroed in on 16,668 diversified accounts whose owners had placed at least 25 trades in the sample period, between January 1990 and November 1996. They found that the top 10 percent of investors “earn excess returns of 15 basis points a day.” That’s a huge number. These talented investors – the researchers believe they have eliminated the luck factor – beat the indexes by 3 percentage points a month!
“This evidence,” Coval and his associates write, “does not support the efficient market hypothesis. The ability of individual traders . . . to select outperforming companies is not confined to small firms or only a few firms in which the traders transact frequently” – so it is not simply the result of taking more risks or trading on inside information.
While the paper has not been subjected to the rigors of peer review for publication and while it covers a fairly short time span, it does suggest some important lessons for small investors:
1. You can beat the market. “Our results suggest that skillful individual investors [can] exploit market inefficiencies to earn abnormal profits,” write Coval, et al. In other words, some people – maybe as many as one-fifth of investors who take the stock market seriously – can really find undervalued companies. So the stock-picking game is not a futile exercise.
2. Still, it is unlikely that you are among the favored few. How can you tell if you are? According to the researchers, you should examine your portfolio over time and see if you have beaten the market with, say, two-thirds or more of your stock picks. That may be an indication that you have the gift. Conversely, if you keep selecting losers, switch to index funds.
3. Individuals seem more likely to beat the market than mutual funds. Why? First, individuals trade much smaller positions, so their purchases and sales don’t affect prices as much. Second, the scholars write, individuals “are less constrained than mutual funds to hold a diversified portfolio or to track the market or a given benchmark.” This is exactly the case made by Peter Lynch, who, in running Fidelity Magellan from 1977 to 1990, was the best fund manager of all time. In his book “One Up on Wall Street,” Lynch argued that small investors had big advantages over fund managers. For one thing, they don’t have to register great figures every quarter or lose their jobs.
Still, some experts do beat the averages over long periods – though they usually do it through risky strategies, such as concentrating their portfolios in only a few stocks. Over the past 10 years, for instance, one of the best-performing mutual funds has been Sequoia (SEQUX), managed by William Ruane and Robert Goldfarb. Sequoia has returned an annual average of 14.2 percent, compared with 7.2 percent for the average fund and 8.6 percent for the benchmark Standard & Poor’s 500-stock index. But Sequoia’s portfolio is highly focused. The top five holdings represent two-thirds of total assets, and the fund owns only 15 companies in all.
Ruane subscribes to Buffett’s philosophy on diversification: Forget it. Buffett likes to quote Mae West, who said, “Too much of a good thing can be wonderful.” There aren’t that many great stocks in the world, so buy lots of the few you find. So Sequoia owns huge chunks of Berkshire itself; Fifth Third Bancorp (FITB); Progressive (PGR), an insurance company; TJX (TJX), discount retailer; and Fastenal (FAST), seller of screws, nuts and bolts; and not much else.
My suggestion is to watch smart managers like Ruane and Goldfarb for stock-picking clues but to play it safe with more diversified portfolios. Don’t own 15 individual stocks, own 30 – or, better, own an index fund and a few managed funds along with 15 individual stocks.
Another way to beat the averages is to focus on smaller companies. Since small-caps are less liquid and less scrutinized than large-caps, they are often more inefficient, slipping under the radar screen. Between 1926 and 2002, small-caps have 2 percentage points more, on average, than large-caps, according to Ibbotson Associates. But the standard deviation of small-caps has been a hefty 33 percent, compared with 21 percent – that is, small-caps are about 50 percent riskier.
In a recent issue, Low-Priced Stock Survey offered one way to exploit the inefficiency of small-caps, recommending six stocks with low price-to-earnings-growth (PEG) ratios. The newsletter estimated each company’s earnings per share for the year ahead, then calculated the price-to-earnings (P/E) ratio based on today’s price. In the case of Guitar Center (GTRC), the top U.S. retailer of guitars and other band equipment, it was 16. Then, the newsletter divided this figure by the estimated earnings growth rate – for Guitar Center, 20 percent. The result: 0.8. The rule of thumb is that a PEG below 1.0 indicates a potential bargain.
The five other small-caps with low PEG ratios: ANSYS (ANSS), provider of simulation software to help computer-aided design; Bio-Reference Laboratories (BRLI), diagnostic medical testing; Cytyc (CYTC), cancer screening; Hibbett Sporting Goods (HIBB), retailer; and Whitman Education (WIX), adult education.
Buffett was right in viewing the efficient-market hypothesizers with profound skepticism. “Observing that the market was frequently efficient,” he wrote of them in 1988, “they went on to conclude incorrectly that the market was always efficient. The difference between the propositions is night and day.” [Emphasis added.]
Yes, but for most small investors, beating the market is practically impossible, and it is dangerous to take foolish chances trying. The good news is that you don’t have to. If the future looks anything like the past, you should be able to double your money in the stock market every seven to eight years by owning index funds or low-cost diversified managed funds. No guarantees, of course. The market isn’t that efficient.
James K. Glassman owns Berkshire Hathaway.
