There are actually two issues 1) Is the market efficient? and 2) Can
someone, using public information, systematically earn higher returns
than those on a suitably risk-adjusted market basket?
These issues are related but they are not the same. If the market
is efficient the answer to the second question is certainly no. If the
market is inefficient, however, it does not follow that the answer (in
practice) to the second question is yes. Some types of inefficiencies
such as two different prices for the same good can and will be
eliminated through profitable arbitrage but when arbitrage is not
possible eliminating market inefficiencies is risky. Even if you knew
that X was a bubble, for example, you can short the stock but you then
run the risk of the bubble flying much higher before it bursts.
Essentially, the failure of Long Term Capital Management was precisely
this problem - right theory but they ran out of capital before they
could profit from the elimination of the inefficiency.
In addition, we must also face the fact that if the market is
inefficient due to investor irrationality it is very likely that we
(yes, you and I) and our agents are also irrational in some respects.
Thus if we care about issue 2 then pointing to bubbles of the past
or arguing that people are irrational or greedy etc. misses the point.
The real test of issue 2 is, Do portfolio managers/stock picking
newsletters or other active strategies outperform a passive index
strategy? And the answer to this question is a resounding NO. Taken as
a group and taking into account transaction costs the active strategies
actually *underperform* the indexing strategy. I don't know anyone who
disputes this finding - note that whether this is because the market is
efficient or portfolio managers are just as irrational as everyone else
is open to question but not relevant to question 2.
At any given time, of course, some portfolio managers beat the
market but, again as a group, no more than you would expect by chance.
Of course there are a few outliers, Warren Buffet and Templeton, for
example. It's quite reasonable to mark these down as a chance but my
own view is that there are a few geniuses out there and that Buffet is
to stock picking what Michael Jordan was to basketball. I no more think
that I could duplicate what Buffet does than I could duplicate what
Michael Jordan does even if Jordan wrote a book explaining how he plays
the game. (Indeed, careful observers of Buffet find that how his
investing decisions cannot be explained soley by reference to his rules
of investing.)
Alex
--
Dr. Alexander Tabarrok
Vice President and Director of Research
The Independent Institute
100 Swan Way
Oakland, CA, 94621-1428
Tel. 510-632-1366, FAX: 510-568-6040
Email: [EMAIL PROTECTED]
