Market Efficient For Indexers example essay topic

web does it mean when people say they 'beat the market'? How do they know they have done so? Beating the market' is a difficult phrase to analyze. It can be used to refer to two different situations: 1. An investor, portfolio manager, fund, or other investment specialist produces a better return than the market average.

The market average can be calculated in many ways (some of which are shady and used to make it look like someone has exceeded market returns), but usually a benchmark like the S&P 500 or the Dow Jones Industrial Average index is a good representation of the market average. If your returns (which you can learn how to calculate here) exceed the percentage return of the chosen benchmark, you have beaten the market - congrats! 2. A company's earnings, sales or some other valuation metric is superior to that of other companies in its industry. How do you know when this happens? Well, if a company beats the market by a large amount, the financial news sources are usually pretty good at telling you.

However, if you want to find out for yourself, you need to break out your calculator and request some information from the companies you want to measure. Many financial magazines do this sort of thing regularly for you - they " ll have a section with a title like 'Industry Leaders. ' We don't suggest you depend on magazines for your investment picks, but these publications may be a good place to start when looking for companies to research. Indexers: A Free Ride on Market Efficiency By Don Luskin Special to The Street. com 4/30/01 10: 14 AM ET URL: web Louis Rukeyser, 'Wall $tree Week with Louis Rukeyser' Dear Lou, Last Friday evening, you inducted John C. Bogle, the founder of Vanguard Funds, into the 'Wall $tree Week with Louis Rukeyser Hall of Fame. ' You correctly credited Bogle with introducing 'the first indexed mutual fund' at Vanguard in 1975. All too often, Bogle is credited too broadly with introducing the very first index fund.

In reality, he was only the first to offer index funds directly to the general public in the form of mutual funds. The idea of the index fund was born in academia. Many great minds contributed to the concept, but first among them are Harry M. Markowitz, Merton Miller and William F. Sharpe, who shared the 1990 Nobel Prize in economics for this work. The first commercial index fund was introduced by Wells Fargo Bank in 1971, four years ahead of Vanguard, under the leadership of John McQuown.

It was created for the Samsonite pension fund's investment portfolio, with an initial investment of only $5 million. Today, at least a trillion dollars are invested in index funds worldwide, probably twice that. Most of it that is managed by banks on behalf of pension funds, university endowments and charitable institutions. Mutual funds make up a trivial portion of worldwide index-fund investing. I used to work at Wells Fargo, starting several years after McQuown and the first generation of indexers had already moved on to other things. Even then, it used to bug us to see Bogle take all the credit -- at least in the mind of the general public -- for inventing index funds.

But at the end of the day, we were delighted to have him out there winning hearts and minds for us. Lou, for Bogle, index funds fit into a larger crusade that you also celebrated on your show: the mission of reducing the costs of investing for the general public. Index funds naturally lower the costs of investing because they eliminate expensive investment managers and traders, and they cut transaction costs by reducing the volume of portfolio turnover. This is important because costs are the single biggest reason that it's so difficult to 'beat the market. ' If you define the market as a comprehensive index like the Wilshire Total Market Value Index, then investors -- on average -- will always under perform by the amount of their costs. The index has no costs whatsoever, but investors have management fees, commissions, research expenses, taxes and so on.

The market is a closed system, in which the winners win at the expense of the losers -- but they both pay costs, so it's a negative-sum game. Costs are a leak in the bucket of performance. Does that mean that it's impossible to beat the market? The most zealous advocates of indexing have claimed just that since 1971. But it isn't true. It is possible to beat the market.

But it's not possible for everyone to beat the market all at the same time. There have to be winners and losers (and both pay costs). So that means that it's very, very hard to beat the market. But not impossible. Does this mean I'm saying that the market isn't efficient? Not at all.

Beating the market is what makes it efficient! Beating the market means you have superior information, and you " ve taken wealth from people who have inferior information. In the process, your superior information gets impounded into market prices. And when academics talk about the efficient market, they simply mean that prices reflect all of the available information. Beating the market is the incentive system for getting that information into prices and making the market efficient. Indexers are 'free-riders' on the process of market efficiency.

They rely on high-cost investors to go out there and take their chances, trying (and often failing) to beat the market, but in the process making market prices efficient. The indexers simply buy the whole market at those efficient prices and get all of the benefits of all those efforts and costs for next to nothing. H. .. if we investors who battle it out every day trying to beat the market are just keeping the market efficient for indexers, maybe it's we who ought to be honored on 'Wall $tree Week' -- not Bogle! Don Beating the '05 Market By Jim JubakMSN Money Markets Editor 1/5/2005 7: 47 AM EST URL: web we begin 2005, the Wall Street consensus is that the year ahead will be OK. Not great like 2003, when the S&P 500 was up 26%.

And not terrible like 2002, when the S&P was down 23%. But OK like 2004, when the index climbed 9.1%. Great. That 9.1% doesn't sound so bad. But I think you can beat that return, just as it was possible to beat the index in 2004. And you don't have to use fancy software, cutting-edge algorithms or proprietary trading strategies to do it.

If 2005 unfolds anything like 2004, you should be able to beat the index by applying just three basic investment strategies. The strategies are pretty easy to understand, although finding the right stocks can take a deceptively large amount of work. But that's what I did in 2004, and the return certainly justified the effort: Although I haven't crunched the final numbers, the return on Jubak's Picks for 2004 will be better than 29.5%. There are no promises that this combination of strategies will clobber the index by the same amount in 2005. And I don't claim that this combination will beat the index every year. I think it's likely to work best in years when earnings growth is modest and the market has a lot to worry about even when it's rallying.

That's a pretty good description of 2004, so I think there's a good chance of using this strategy to beat the index again in 2005. So what are the three parts of this index-beating strategy? And how do you apply them for 2005? Look for Double-Digit Earnings Growth First, understand what the Wall Street consensus values, and buy a core of stocks that will deliver it. For 2005, I think that means buying stocks that will deliver double-digit earnings growth.

When anything -- diamonds, oil, left-handed power pitchers -- is in short supply, the price climbs. In next year's stock market, double-digit earnings growth will be the scarce commodity. The U.S. economy is expected to grow next year, but at a slower rate, with GDP growth dropping to 3% in the first quarter of 2005 from an actual 3.9% in the third quarter of 2004, and a projected 4% in the fourth quarter of 2004. The projected slowdown will hit both the consumer and business sectors. Consumer-spending growth is projected to drop to 3.2% in the first quarter of 2005 from 5.1% in the third quarter of 2004, while business-investment growth is projected to plunge to 5% in the first quarter of 2005 from 13% in the fourth quarter of 2004, when companies were spending to take advantage of expiring tax breaks. Corporate profits and earnings will slow with the economy.

Growth in corporate profits hit a 20-year high of 28% year to year in the first quarter of 2004, and has been on a downward trend since. Growth in earnings per share for the stocks in the S&P 500 is likely to come in near 20% for 2004, but is currently projected to drop to just 10.6% in 2005 (a big drop early in the year, picking up in the last half, according to Thomson First Call). Two Places to Seek Growth In an environment of slowing growth, companies that can deliver predictable growth at a rate above the 10.6% benchmark for the S&P 500 will get a two-stage boost. First, earnings growth itself will lift the price of shares. Second, the scarcity of double-digit earnings growth in the period should boost the multiple -- the price-to-earnings ratio -- that investors are willing to pay for this growth. Simple enough.

But finding the stocks that will deliver double-digit growth when the economy as a whole is slowing is a huge challenge. I'd look for this growth in two places: among stocks that Wall Street already projects to grow earnings per share in 2005 at better than the 10.6% S&P benchmark growth rate and that currently trade at a price-to-earnings ratio below the 21.3 P / E of the S&P 500. Among the candidates my screen pulled up were big-caps American International Group (AIG: NYSE), Golden West Financial (GDP: NYSE) and Pac car (PAR: Nasdaq), and smaller stocks such as Smithfield Foods (SFD: NYSE), Wolverine World Wide ( : NYSE) and Ball (ALL: NYSE). And look for growth among the cyclical stocks that Wall Street projects will fall just short of that 10.6% benchmark in 2005. I think Wall Street is underestimating the power of a cheap dollar to boost sales at these companies in 2005 and to keep the cycle running near peak levels for another year. A stock like Deere (DE: NYSE), with its projected 8.6% earnings per share growth in fiscal 2005, and its big exposure to the fall and (in 2005) rise of U.S. farm exports, fits this description exactly.

Other stocks like this include Briggs & Stratton (BGG: NYSE), Engle hard (EC: NYSE) and RPM International (RPM: NYSE). Where Will Wall Street Be Wrong? Second, understand what might go wrong with the consensus and buy a core of stocks to profit from the inevitable deviation of reality from Wall Street projections. The Wall Street consensus on earnings growth and stock market return for 2005 rests on these assumptions: o Energy prices won't go so high that they drag down growth. o Growth in China (the other critical engine of global growth besides the U.S.) won't significantly falter. o U.S. interest rates will rise at the measured pace that the Federal Reserve has promised. The likelihood that 2005 will follow this script is just about nil, in my opinion. The very small spread between global oil supply and global oil demand -- and the increasing difficulty and expense of expanding supply -- make energy prices extremely sensitive to the slightest disruption in supply.

It's wishful thinking to believe that this violent and chaotic world of ours will manage to get through an entire year without something -- Russian politics, terrorism, Saudi politics, hurricanes, Nigerian politics, the war in Iraq, Venezuelan politics -- producing another spike in oil prices that will leave oil prices permanently higher even when it retreats. On weakness, buy the majors such as Exxon Mobil (XOM: NYSE) and BP (BP: NYSE), and the minors Swift Energy (SFY: NYSE), Apache (APA: NYSE), Southwestern Energy (SAN: NYSE), En Cana (ECA: NYSE) and St. Mary Land and Exploration (SM: NYSE), to name just a few. Don't forget the oil-service stocks and drillers, starting with Schlumberger (SLB: NYSE) and including, but not limited to, National-Oil well (NOI: NYSE), Smith International (SII: NYSE), Trans ocean (RIG: NYSE) and Diamond Offshore Drilling (DO: NYSE). For good measure, add a dollop of coal, too: Penn Virginia (PVA: NYSE), Peabody Energy (BTU: NYSE) and BHP Billiton Limited (BHP: NYSE). The uncertainty about how far China will trim its growth rate (and whether its bankers and economists will make a mistake and send growth tumbling instead) will make it difficult to duplicate the successful raw materials plays of 2004.

Later in the year, if China's growth policies are no longer roiling the commodity markets in copper, nickel and iron, it would be worth revisiting stocks such as Southern Peru Copper (PCU: NYSE), Inco (N: NYSE) and Phelps Dodge (PD: NYSE). And finally, while I think the market's trust in Federal Reserve Chairman Alan Greenspan is touching, it's wise to remember that not all global financial markets are within Greenspan's control. The huge U.S. budget and trade deficits mean that interest rates are hostage to the willingness of overseas investors to hold dollars. In 2004 through December, the U.S. Treasury increased the supply of U.S. Treasury debt by $400 billion, but foreign investors bought up $800 billion in Treasury notes and bonds.

That's one major reason why long-term interest rates in the U.S. finished 2004 about where they started the year, despite the Fed's increase in short-term interest rates from 1% to 2.25%. If foreigners, at this point largely Asian central banks, decide to temper their love affair with the dollar, U.S. interest rates will go up, with or without the Fed. If a cheap U.S. dollar and the consequent price increase in everything we import fail to stem our appetite for imports, those higher prices will give U.S. companies the ability to raise their own prices. That feeds into inflation, and higher inflation could provoke the Federal Reserve to move at a quicker-than-measured pace. Profit from this by buying financial's that have the ability -- due to their product mix and their management skills -- to increase the spread they collect on their loans, mortgages and credit cards if interest rates go up. I'd look at adjustable-rate mortgage specialists such as Golden West Financial and credit card giants such as MBNA (KRB: NYSE) and Capital One Financial (COF: NYSE).

Keep an Eye on the Long Term, Too And third, ignore the short-term trends of 2005 to keep adding to positions in stocks that will benefit from the long-term trends toward higher inflation, higher interest rates and greater uncertainty. Stocks like these won't burn up the track in any one year -- unless we get some truly terrible global event. Over the next decade, though, they will consistently add percentage points to your portfolio's return. I'm talking about gold stocks such as Newmont Mining (NEM: NYSE), Placer Dome (PDG: NYSE) and Glam is Gold (GIG: NYSE), and land and real-asset stocks such as The St. Joe Company (JOE: NYSE), Tej on Ranch (TRC: NYSE) and Rayon ier (RUN: NYSE). During the next few weeks, I'll strip away the end-of-the-year plays in technology and biotech that I added to Jubak's Picks in a not very successful effort to get more bang for my portfolio out of the year-end rally. As I sell those, what you " ll see is a portfolio that looks very much like the one I've described in this column.

As the new year unrolls, I'll look to add stocks like the ones I've described here to the portfolio when the price is right in an effort to beat the index in 2005. Looking ahead, 2005 promises to be another interesting -- and let's hope profitable -- year. Thanks to everyone who read Jubak's Journal, emailed me or contributed to one of my columns in 2004. Market Efficiency (updated 27 Feb 99) The efficient market hypothesis (EMH) says that at any given time, asset prices fully reflect all available information.

That seemingly straightforward proposition is one of the most controversial ideas in all of social science research, and its implications continue to reverberate through investment practice. As MIT finance professor Andrew Lo writes in the introduction to two volumes that collect the key articles on the EMH, 'it is disarmingly simple to state, has far-reaching consequences for academic pursuits and business practice and yet it is surprisingly resilient to empirical proof or refutation'. The simple statement implies but does not limit information to be strictly financial in nature. It may incorporate investor perceptions whether correct or otherwise. This richer interpretation of the EMH provides for variations from its stronger forms, which suggest that further data study, unless perhaps insider-based, is unlikely to be fruitful. The second derivative of an investor perception overlay on financial information allows for intuition, judgment and the quest for new tools that markets may discover in the pursuit of profits above the average.

The chief corollary of the idea that markets are efficient, that prices fully reflect all information, is that price movements do not follow any patterns or trends. This means that past price movements cannot be used to predict future price movements. Rather, prices follow what is known as a 'random walk', an intrinsically unpredictable pattern. The random walk is often compared to the path a sailor might follow out of a bar after a long, hard night drinking. In the world of the strong form EMH, trying to beat the market becomes a game of chance not skill. There will be superior performers generating better investment returns but only because statistically there are always some people above the average and others below.

Hence, debate about the EMH becomes a question of whether active portfolio management works: is it possible to beat the market or are you better off avoiding the transactions costs and simply buying an index fund? And, as an active manager, the issue is whether it works for me, a sample size of one? (see ACTIVE PORTFOLIO MANAGEMENT) The answer to these questions depends not only on whether you accept the EMH but, if so, in what form. There are essentially three: o The weak form of the EMH asserts that all past market prices and data are fully reflected in asset prices. The implication of this is that technical analysis cannot be used to beat the market (see TECHNICAL ANALYSIS). o The semi-strong form of the EMH asserts that all publicly available information is fully reflected in asset prices. The implication of this is that neither technical nor fundamental analysis can be used to beat the market. o The strong form of the EMH asserts that all information - public and private - is fully reflected in asset prices. The implication of this is that not even insider information can be used to beat the market.

Gurus of efficient markets: Eugene Fama and Burton Malkiel Although the concept of the random walk can be traced back to French mathematician Louis Bachelier's doctoral thesis 'The Theory of Speculation' in 1900, the EMH really starts with Nobel Laureate Paul Samuelson and his 1965 article, 'Proof that Properly Anticipated Prices Fluctuate Randomly'. But it was Chicago finance professor Eugene Fama with his 1970 paper 'Efficient Capital Markets' who coined the term EMH and made it operational with the foundational epithet that in efficient markets, 'prices fully reflect all available information'. Fama argued that in an active market of large numbers of well-informed and intelligent investors, stocks will be appropriately priced and reflect all available information. In these circumstances, no information or analysis can be expected to result in out performance of an appropriate benchmark. Because of the wide availability of public information, it is nearly impossible for an individual to beat the market consistently. Another professor, Burton Malkiel of Princeton, popularized the notion of the random walk implication in his bestseller A Random Walk Down Wall Street.

He suggested that throwing darts (or, more realistically, a towel) at the newspaper stock listings is as good a way as any to pick stocks and is likely to beat most professional investment managers. Malkiel does suggest in the later part of his work how those who insist on trying to beat the market might attempt to do so, but he indicates that they are unlikely to be successful. Since the EMH was formulated, countless empirical studies have tried to determine whether specific markets are really efficient and, if so, to what degree. Andrew Lo's volumes bring together some of the most significant contributions, including a paper called simply 'Noise' by the late Fischer Black. It says: 'Noise in the sense of a large number of small events makes trading in financial markets possible. Noise causes markets to be somewhat inefficient, but often prevents us from taking advantage of inefficiencies.

Most generally, noise makes it very difficult to test either practical or academic theories about the way that financial or economic markets work. We are forced to act largely in the dark. ' Counterpoint A central challenge to the EMH is the existence of stock market anomalies: reliable, widely known and inexplicable patterns in returns. Commonly discussed anomalies include size effects, where small firms may offer higher stock returns than large ones; and calendar effects, such as the 'January effect' - which seems to indicate that higher returns can be earned in the first month compared to the rest of the year - and the 'weekend effect' or 'blue Monday on Wall Street' - which suggests that you should not buy stocks on Friday afternoon or Monday morning since they tend to be selling at slightly higher prices. There are also the supposed indicators of undervalued stocks used by value investors, such as low price-to-earnings ratios and high dividend yields (see VALUE INVESTING). But while there is no doubt that anomalies occur in even the most liquid and densely populated markets, whether they can be exploited to earn superior returns in the future remains open to question.

If anomalies do persist, transactions and hidden costs may prevent them being used to produce out performance, as well as the rush of other investors trying to exploit the same anomalies. It may be possible that opportunities arise in quanta bursts and then disappear rather like the track in a cloud chamber. If so, by the time we wish to measure the recurrence of an event, it has occurred and passed by, unlikely to be repeated in the same form. Further challenges to the EMH come from the study of behavioral finance, which examines the psychology underlying investors' decisions and uses it to explain such phenomena as stock price over-reaction to past price changes and stock price under-reaction to new information (see INVESTOR PSYCHOLOGY). Many studies seem to confirm the implication of over- and under-reaction that there are 'pockets of predictability' in the markets: contrarian strategies of buying 'losers' and selling 'winners' can generate superior returns; and prices do tend to regress to the mean. A light-hearted yet cutting angle on the impact of psychology on market efficiency turns up in a 1997 article on the website of MIT economics professor Paul Krugman.

Attending a big conference of money managers, Krugman detects 'The Seven Habits of Highly Defective Investors', the behavioral traits that he says make the markets anything but efficient: think short-term; be greedy; believe in the greater fool; run with the herd; overgeneralize; be trendy; and play with other people's money. 'What I saw', Krugman recounts, 'was not a predatory pack of speculative wolves: it was an extremely dangerous flock of financial sheep. ' Of course, the vast majority of successful professional investors claim they have disproved the EMH. (The unsuccessful are engaged in other pursuits giving this sample technique hindsight bias.) And any active manager, no matter what his record, will be eager to argue that the markets are not efficient in order to justify his work as an agent for hire by others. Even the financial media has a powerful interest in decrying the EMH: if all information is fully reflected in prices, what value is there in the information they supply? But are the investors who really beat the market consistently over, say, a five year period simply the inevitable result of a standard distribution?

After all, if a hundred people toss coins five times in a row, the probability is that two or three of them will have called correctly five times straight. In the same way, probability indicates that there will be someone occupying the Warren Buffett investment performance slot and it will be someone who has done the right things - but is it skill or luck? And by the time we might have statistical verification, such a long period - fifty years or so - will have passed to make the study useless. And, of course, just as the challenge of stock picking is to identify a superior performer before the fact rather than in hindsight, so it is with investment managers. In many cases, strong performers in one period frequently turn around and under perform the next, and, as statistics would predict, a number of studies show that there is little or no correlation between strong performers from one period to the next. Nevertheless, as Peter Bernstein points out in a 1998 address to European financial analysts, 'even though beating the market is increasingly difficult, more and more people undertake the effort'.

He suggests that 'the enormous volume of trading in today's markets is an important indication that market efficiency in the pure sense has no relevance to the real world of investing', and that 'equilibrium prices are impossible in a dynamic and restless world of noise traders in the market'. Andrew Lo adds: 'As with any other industry, innovation and creativity are the keys to success, so why should we find it surprising that those who are capable of such feats outperform the rest of the pack? If the EMH in its classical form seems to be violated so often, maybe we economists ought to re-examine our theory instead of arguing that the world is crazy. ' (see FINANCIAL ENGINEERING). Guru response Burton Malkiel responds with extracts from the latest edition of his classic book.

In a new chapter entitled 'The Assault on the Random-Walk Theory: Is the Market Predictable After All?', he writes: 'I have reviewed all the recent research proclaiming the demise of the efficient-market theory and purporting to show that market prices are, in fact, predictable. My conclusion is that such obituaries are greatly exaggerated and the extent to which the stock market is usefully predictable has been vastly overstated. ' 'First, there are considerable questions regarding the long-run dependability of these effects. Many could be the result of 'data snooping', letting the computer search through the data sets of past securities prices in the hopes of finding some relationships. With the availability of fast computers and easily accessible stock market data, it is not surprising that some statistically significant correlations have been found, especially because published work is probably biased in favor of reporting anomalous results rather than boring confirmations of randomness. Thus, many of the predictable patterns that have been discovered may simply be the result of data mining - the result of beating the data set in every conceivable way until it finally confesses.

There may be little confidence that these relationships will continue in the future. ' 'Second, even if there is a dependable predictable relationship, it may not be exploitable by investors. For example, the transaction costs involved in trying to capitalize on the January effect are sufficiently large that the predictable pattern is not economically meaningful. Third, the predictable pattern that has been found, such as the dividend-yield effect, may simply reflect general economic fluctuations in interest rates or, in the case of the small-firm effect, an appropriate premium for risk. Finally, if the pattern is a true anomaly, it is likely to self-destruct as profit maximizing investors seek to exploit it. Indeed, the more profitable any return predictability appears to be, the less likely it is to survive.

' 'It is abundantly clear that techniques that work on paper do not necessarily work when investing real money and incurring the large transactions costs that are involved in the real world of investing. As a successful portfolio manager (ranked in the top 10% of all money managers) once sheepishly told me, 'I have never met a back test I didn't like'. But let's never forget that academic back tests are not the same thing as managing real money. ' 'In summary, pricing irregularities and predictable patterns in stock returns may well exist and even persist for periods of time, and markets can be influenced by fads and fashions.

Eventually, however, any excesses in market valuations will be corrected. Undoubtedly, with the passage of time and with the increasing sophistication of our databases and empirical techniques, we will document further apparent departures from efficiency and further patterns in the development of stock returns. Moreover, we may be able to understand their causes more fully. But I suspect that the end result will not be an abandonment of the belief of many in the profession that the stock market is remarkably efficient in its utilization of information. ' Where next? There is what Andrew Lo calls 'a wonderfully counter-intuitive and seemingly contradictory flavor' to the idea of information ally efficient markets: the greater the number of participants, the better their training and knowledge and the faster the dissemination of information, the more efficient a market should be; and the more efficient the market, the more random the sequence of price changes it generates, until in the most efficient market, prices are completely random and unpredictable.

That is to say that the more lemmings there are, the less likely they all are to fall over the cliff. Similarly, if everyone believes the market is efficient, then it will no longer be efficient since no one will invest actively. In effect, efficient markets depend on investors believing the market is inefficient and trying to beat it. In reality, markets are neither perfectly efficient nor completely inefficient.

All are efficient to a certain degree - and new technology probably serves to make them more efficient. But some markets are more efficient than others. And in markets with substantial pockets of predictability, active investors can strive for out performance. Peter Bernstein concludes that there is hope for active management: 'the efficient market is a state of nature dreamed up by theoreticians. Neat, elegant, even majestic, it has nothing to do with the real world of uncertainty in which you and I must make decisions every day we are alive. ' Read on In print Andrew Lo, Market Efficiency: Stock Market Behavior in Theory and Practice, two volumes of the most important articles on the subject, including Eugene Fama's seminal 1970 review, Paul Samuelson's 1965 article and Fischer Black's 1986 article Andrew Lo and Craig Mckinlay, A Non-Random Walk Down Wall Street Burton Malkiel, A Random Walk Down Wall Street, a long-time bestseller, first published in 1973 and now in preparation for its seventh edition Online web. mit. edu / krug man / - Paul Krugman's website web - website of the Social Science Research Network, which features many important papers in investment, including Eugene Fama's 'Market Efficiency, Long-term Returns and Behavioral Finance'.