November 08, 2010
Arbitrariness in Markets
Posted by Jeff Schwartz

One issue I’ve been thinking about recently is the arbitrary nature of investing and how that relates to securities regulation and retirement savings.

Investors owe much of their stock-market returns to chance.  This is particularly true for retirement savers who contribute to passively managed index funds each month.  These investors have no control over what will happen in the market; they essentially take it as a matter of faith that their money will grow.  Due to chance alone, however, different investors will have different results.  And over time disparities can become dramatic.  A striking study by the Brookings Institution, which assumed steady contributions to a pure equity portfolio over forty years, found that different investors had vastly different savings as a result purely of the market’s performance during their investing lifetimes.  The luckiest investors had 7x more savings than the unluckiest.

Returns from active investing are also greatly influenced by chance market moves.  For example, a long-only equities mutual fund will usually do well when the market is on an upswing irrespective of the manager’s stock-picking skill.  Moreover, many of those managers who earn market-beating returns in any particular year will owe their excess returns to chance.  With so many mutual funds searching for diamonds in the rough, some will succeed merely as a result of luck. 

Indeed, both theory and empiricism suggest that luck accounts for a great deal of excess returns.  Both EMH advocates and critics agree that market volatility follows a highly unpredictable walk.  If this is the case, scant few will be able to skillfully outmaneuver the crowd.  This conclusion is backed up by a recent study by Eugene Fama and Kenneth French, which searched directly for the presence of skill in actively managed mutual funds.  They found little. 

Thus, retail investors who happen to be in successful actively managed funds likely owe their returns to chance.  Moreover, if retail investors find themselves among the fortunate few who participate in funds run by managers with true skill, it’s likely their fund choice was a lucky guess.  Fama and French used complex statistics to separate the wheat from the chaff, whereas ordinary investors must rely mainly on past returns, which are a dubious measure of skill owing to their problematic entanglement with luck.

Thus, we have chance, layered on top of chance, layered on top of chance.  I think that recognizing this aspect of investing has policy implications, which I’ll turn to in my next posts.

Finance, Investing, Securities | Bookmark

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