Beating the Market

THE SOURCE: “The Elusiveness of Investment Skill” by Robert A. Jaeger, in _The Journal of Wealth Management_, Fall 2008.

You’ve heard it a million times: Nobody can beat the stock market, so just stash your investment dollars in index mutual funds and settle for “the average return.” Behind that nostrum is the so-called efficient market theory, which holds that stock prices already reflect all the available information about a company, making it impossible for anybody to get a leg up.

Efficient market theory no longer dominates the academic discipline of finance, says Robert A. Jaeger, senior market strategist at BNY Mellon Asset Management, but it has left a legacy: the notion that there is no such thing as a skilled investor, and no way to distinguish skill from luck. Not true, Jaeger argues.

Two strands of the theory challenge the notion of skill. One is the idea that “there are no free lunches”: No market inefficiencies exist that might enable investors to make money without taking risk. Risk, the argument goes, will always catch up with successful investors, reducing their returns to the norm. The second idea is that “nobody knows anything”: Investors can’t predict the future. But, Jaeger says, those who have skill as investors don’t exploit market inefficiencies or use vatic powers to see tomorrow’s stock market. They make “intelligent judgments about risk and reward.” Paraphrasing billionaire speculator George Soros, he writes, “The question is not whether you’re right or wrong—it’s how much you make when you’re right and how much you lose when you’re wrong.”

Efficient market theorists believe that investors are totally rational. In fact, Jaeger says, they are driven by fear, greed, and a host of behavioral “biases.” But irrationality still doesn’t create free lunches or predictable prices. Even during bubbles and panics, which are prime moneymaking opportunities for savvy investors, there are no riskless profits and no way to forecast market turning points. Many hedge funds lost money “selling short” too early during the market bubble of the past few years, and many sovereign wealth funds lost money buying too early during the ensuing panic.

Although the stock market is unpredictable, efficient market theorists are wrong to claim that it is a “random walk,” Jaeger adds. Random events can’t be explained even after the fact, but market events can.

Theorists resort to the example of coin tosses to explain the success of the few investors who do manage consistently to outpace the market. Just as it’s possible to get 20 straight “heads” when tossing a coin, so it’s possible by sheer luck to beat the market 20 years running. But there’s another possibility, Jaeger points out. Maybe the coin is biased—weighted in such a way that heads is more likely to turn up. A successful investor’s performance may likewise be “weighted” by skill.

None of this means you should rush to place bets on your favorite stocks and mutual funds. Skill is rare, according to Jaeger. He is himself a denizen of the hedge fund world (and a former professor of philosophy at Yale), and he says that prowess is no more common there than elsewhere. Hedge fund managers have more freedom to exploit unusual investment strategies than other managers do, but that also gives them more ways to get into trouble. A bad stumble one year can erase several years of outsize returns. Most discouraging of all, even a 20-year record of outstanding skilled performance is no guarantee of a good showing next year—winners can freeze up, overreach, or fail to adjust to changing conditions. As they warn in the mutual fund business, past performance is no guarantee of future results.