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20 The Power of an Idea Whether EMH and MPT do a good job of describing markets or are pure blather, they have fired the imagination not only of academe, but also of Wall Street. Prior to these theories, investment managers and mutual funds were measured on the rates of retum their portfoUos generated, usually compared to the S&P 500 or the Dow Jones, with no adjustments made for risk. The development of modem portfolio theory resulted in academics and consultants putting risk measurements into the formula to determine how well a portfolio performed. If a portfolio eamed the market retum with higher risk, it was deemed on a risk-adjusted basis to have underperformed the market." Risk measurement has grown into a multi-billion-dollar industry and influences the decisions of countless investors, either directiy or through their pension funds. If you buy a mutual fund from Charles Schwab, as millions do, you might take your cue from its recommended list. To rank funds, Schwab and most other mass marketers calculate risk as well as performance. Risk is measured according to academic principles which, produced, with two exceptions. Some new studies show daily and weekly predictability in price movements from past movements. But after transaction costs there is nothing much left. A second area of new support for efficient markets, according to Fama, comes from event studies, the study of specific events and how they affect a stock or the market. In the past twenty years, hundreds of such studies have been undertaken. Fama concludes that "on average stock prices adjust quickly to information about investment decisions, dividend changes, changes in capital structure, and corporate-control transactions." He also refers to another large body of research from event studies that shows the opposite conclusion: rather than adjusting rapidly to new information, prices adjust slowly and thus inefficiently. Nevertheless, he concludes his review article with the statement: "The cleanest evidence of market-efficiency comes from event studies, especially from event studies on daily retums." We will retum to Professor Fama and his assertions in the final chapter. A discussion of the efficient markets classic, albeit almost completely refuted, master creation, modem portfolio theory (MPT), is found in Appendix A. MPT details how the rational marketplace supposedly works, and is widely used to make investment decisions by some of the largest banks, pension funds, brokerage houses, and perhaps by a mutual fund you own.
* The Russell 2000 is the most widely followed small-company index. as we shall see in chapter 14, have now been discredited by leading academic researchers themselves, and are probably money-losers. Similar risk measurements are used by consultants who recommend money managers to large pension funds and to other clients, and to the wrap-fee programs of the large brokerage houses, which recommend money managers for millions of smaller customers. On the theory that you cannot beat the market over time, hundreds of billions of dollars have gone into various forms of index funds, from the S&P 500 to the Russell 2000.* Leaders in the indexing business, such as Vanguards Index 500 fund. Wells Fargo, and Bankers Trust, have attracted large portions of these flows. Finally, a myriad of other products has come out of EMH and MPT, ranging from small cap stocks to MPT strategies for money management firms. In the last few dozen pages, we have reviewed the academic disman-tiement of the two most important market theories of our day, and their replacement, at least intellectually, by a third. The new theory has swept through the universities, and then progressively through the financial press, individual and corporate investors, and among professionals themselves. On the assumption that it is impossible to outdo the market, many professionals have radically altered their techniques and their concept of risk-a fitting tribute to the power of an idea conceived little more than three decades earlier. The theory so pervades professional investing and academia that Michael Jensen, one of the important contributors to its development, stated some years back, "Its dangerously close to the point where no graduate student would dare to submit a paper criticizing the hypothesis." At the same time, it is sad, for in accepting the new way, the money manager acknowledges that his or her prime raison detre-to eam superior retums for the client-is beyond reach. But its not time to throw in the towel yet. Ahhough the efficient market hypothesis seems to unravel some of the investment knots we have seen, it fails to untie many others. How, for instance, could professional investors as a group underperform the market for decades? How could the bulk of professional opinion prove so consistently and dramatically wrong at cmcial market tuming points? Or, if investors are so unfailingly rational, how could euphoria and panic prevail so often? More to the point, if the market were so efficient, how could the 1987 crash have happened? Particularly when thousands of investment professionals were not only trained in, but carefully followed, efficient market
teachings? Their numbers included prominent academics who developed advanced theories built on EMH and MPT that were obUterated in the crash. These professionals backed their decisions with hundreds of billions of dollars. None of these things could happen, according to the theory. One nonacademic observer noted that Compaq Computer fell 65% between 1991 and 1993» with its price declining from $9 to $3, before soaring to $79 in late 1997. Fundamentals varied little during this time. "When was the market efficient?" he asked. "When it took Compaq down to 3 or drove it up to 79?" Efficient markets should not behave this way. Thus, before accepting the academic theory that ours is the best of all possible financial worlds-that our advanced analytical methods result in highly efficient markets-lets move back to the questions posed a few pages earUer. Are there flaws in the analytical methods themselves-flaws so serious that even trained professionals cannot avoid them-that lead to consistent investment errors? We will find the surprising answers in the next section.
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