Random Walks and Index Funds

The efficient markets hypothesis is a theory about how financial markets work. The theory is probably not completely true: there is reason to doubt that stockholders are always rational and that stock prices are informationally efficient at every moment. Nonetheless, the efficient markets hypothesis does much better as a description of the world than you might think.

There is much evidence that stock prices, even if not exactly a random walk, are very close to it. For example, you might be tempted to buy stocks that have recently risen and avoid stocks that have recently fallen (or perhaps just the opposite). But statistical studies have shown that following such trends (or bucking them) fails to outperform the market. The correlation between how well a stock does one year and how well it does the following year is almost exactly zero.

Some of the best evidence in favor of the efficient markets hypothesis comes from the performance of index funds. An index fund is a mutual fund that buys all the stocks in a given stock index. The performance of these funds can be compared with that of actively managed mutual funds, where a professional portfolio manager picks stocks based on extensive research and alleged expertise. In essence, an index fund buys all stocks, whereas active funds are supposed to buy only the best stocks.

In practice, active managers usually fail to beat index funds. For example, in the 10-year period ending January 2013, 84 percent of stock mutual funds performed worse than a broadly based index fund holding all stocks traded on U.S. stock exchanges. Over this period, the average annual return on stock funds fell short of the return on the index fund by 1.21 percentage points. Most active portfolio managers failed to beat the market because they trade more frequently, incurring more trading costs, and because they charge greater fees as compensation for their alleged expertise.

What about the 16 percent of managers who did beat the market? Perhaps they are smarter than average, or perhaps they were luckier. If you have 5,000 people flipping coins ten times, on average about 5 will flip ten heads; these 5 might claim an exceptional coin-flipping skill, but they would have trouble replicating the feat. Similarly, studies have shown that mutual fund managers with a history of superior performance usually fail to maintain it in subsequent periods.

The efficient markets hypothesis says that it is impossible to beat the market. The accumulation of many studies of financial markets confirms that beating the market is, at best, extremely difficult. Even if the efficient markets hypothesis is not an exact description of the world, it contains a large element of truth.

Reference

Principles of Economics