There’s a saying that a monkey throwing darts can pick a portfolio of stocks just as well as a stockbroker sitting behind a desk. This isn’t merely a taunt at stock brokers, it is the foundation of The Random Walk Theory, originally published by French economist, Jules Regnault in 1863, then popularized in 1973, by Princeton University Professor Burton Malkiel. The essence of the theory is that a seasoned investment manager is no more likely to achieve superior stock market returns than a monkey throwing darts at the stock market page of a newspaper. (Can you tell this is an old theory)?
Eugene F. Fama, the University of Chicago economist agrees. Professor Fama, often called “the father of modern finance,” was awarded the 2013 Nobel Prize in Economics for developing the Efficient Market Hypothesis, in which he proved that markets are inherently efficient. His findings eventually led to the development of stock index funds. Beyond the potential of index funds, Dr. Fama's work showed that it's highly improbable individuals can pick a fund manager who will beat the market in any one year, let alone beat it the next year or the year after.
Through no fault of our own, we are inundated with commentary. Today, the latest sound-bite, headline, or cover story feels like it carries more weight than time-tested knowledge. With so many distractions competing for our attention, it is all too easy to overlook scrutinized insights, like Dr. Fama's research, in favor of the most recent ‘10 Hottest Funds’ list. So the question becomes, ‘do you have an investment philosophy, or do you react to a good sales pitch?’
With the Efficient Market Hypothesis in mind, consider how your investment strategy achieves returns. Are you intent on finding that home run? Apple just before the iPhone was introduced, for example? Or what about Pfizer shortly before the release of the revolutionary cholesterol drug, Lipitor? Conversely, Professor Fama’s research suggests a philosophy that includes the following principles:
- Since there is no evidence that active stock trading consistently beats the market, an investor should not pay additional management fees for a promise not delivered.
The largest determinants of investor return are low costs and low portfolio turnover.
- Since an investor cannot consistently beat the market, the objective should be to meet the market returns as inexpensively as possible.
Nothing in life is risk-free and the same holds true for investing. While superior investment returns may be achieved with a greater allocation of stocks, they also carry a higher degree of risk, as measured by volatility. So, how do you strike a balance between ‘reward for risk’ and ‘volatility’? For investors who are skiers, think of it as skiing the blue square run, instead of the black diamond. It is possible to enjoy yourself on both runs, but on the blue run, you’re likely putting yourself in significantly less danger.
This begs the question, as an investor, how do you enjoy the proverbial black diamond run, while skiing on the less risky blue square run? Your asset allocation helps you find the answer.