Can you really outperform the stock market over time? Efficient market theorists believe that it's almost impossible and those who do are lucky, not skilled. Surely successes like Warren Buffett would disagree.
Can you really outperform the stock market over time? Or is trying to do so just a waste of time — a mug’s game?
That’s what we set out to resolve two weeks ago at FreedomFest in Las Vegas, where I debated Garett Jones, a macroeconomist at George Mason University and BB&T Professor for the Study of Capitalism.
Chairing the debate was Joel Stern, a well-regarded economist and businessman, and former long-time panelist on Louis Rukeyser’s Wall Street Week.
Jones is an advocate of the efficient market hypothesis, the theory that all material public information is immediately incorporated into the price of stocks by rational, self-interested investors. Therefore, he argues, it is highly unlikely (virtually impossible) to beat the market.
He gave a PowerPoint presentation making a persuasive case for indexing, showing how the vast majority of actively managed mutual funds have historically failed to beat their benchmark over time.
I conceded that much of what Jones had said was true, and perhaps even understated. Over periods of a decade or more, for instance, approximately 95% of actively managed funds fail to beat their benchmarks.
However, there is a big difference between arguing that all stocks are efficiently (accurately) priced all the time and recognizing that most stocks are efficiently priced most of the time.
After all, can you really believe that when technology and Internet stocks soared to absurd levels in the late 1990s that they were perfectly priced? Do you accept that when the Dow crashed to 6,500 during the depths of the recent financial crisis that every stock was trading at a valuation that perfectly reflected the long-term growth prospects of those 30 businesses?
I don’t. And neither should you. Warren Buffett — just one of many individuals who have beaten the market averages over the long haul — once commented that he should endow a chair so that efficient market theory is taught at leading universities. Not because it is true, but because it would eliminate his competition.
Skill, not luck
Of course, efficient market theorists concede that some people beat the market over long periods of time but that they aren’t necessarily skilled, just lucky. If that were the case, however, Berkshire Hathaway’s outstanding performance could just as easily have been accomplished not by a financial genius like Buffett but by a housewife in Duluth.
Beat the market long enough — over decades, say — and efficient market theorists will finally admit that something more than luck must have been involved. But by then, the person generating the great returns may have quit the business.
When mutual fund great Peter Lynch ran the Magellan Mutual Fund from 1977 until 1990, for instance, he averaged a 29.2% annual return. That was incredible — and clear evidence of skill. But then he retired. (And, of course, the Magellan Fund immediately sank in the ratings.)
I conceded to Jones that the vast majority of actively managed mutual funds are a waste of money. I agreed that you can’t accurately forecast the economy or successfully time the stock market.
But I pointed out that there are proven ways to beat the market, like riding the coattails of knowledgeable insiders. The reason is not hard to fathom. Corporate officers and directors have an unfair advantage: access to material, non-public information that gives them a clear edge when they go into the market to trade.
They know the direction of sales since the last quarterly report, new products and services in development, the gain or loss of major customers or key employees, the pending settlement of outstanding litigation and plenty of other valuable stuff.
They can hardly forget all these things when they purchase or sell shares of their own companies. That’s why their actions bear watching … and often lead to outsized profits. (This is not just theory. I’ve been writing The Insider Alert, a stock trading service based on insider buying, for well over a decade.)
Yet Jones — and even the avuncular and witty moderator Joel Stern — refused to concede even this. Even if you are acting in concert with the most knowledgeable insiders with material, non-public information, they still don’t believe you can beat the market.
Which is fine with me. After all, Buffett is right. Less competition makes markets even more inefficient.
And that’s where the real money is made.
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