In 1973, Princeton economics professor Burton Malkiel caused a stir with his book, A Random Walk Down Wall Street. Considered heretical at the time by Wall Street money managers, Malkiel asserted his research affirmed that one could do as well as professional stock pickers by throwing darts at the financial page of a newspaper and buying the stocks the darts hit.
At the heart of Malkiel’s work is the Efficient Market Model (EMM). As Malkiel states it, EMM acknowledges that prices are always wrong as representations of value, but it’s essentially impossible for investors to tell whether a given price is higher or lower than the true value of an asset.
This powerful thesis has had a dramatic impact on the world of investing. When the book was published, index investing and index funds were unknown. Two years after its publication, Vanguard introduced its Vanguard 500 Fund, the first publicly available way for investors to buy a bit of every stock in the broad-based Standard & Poor’s 500 Stock Index. Two years after that, Malkiel joined the Vanguard Board, on which he actively participated for the next 28 years.
It took about two decades for index, or “passive,” stock investing to make significant inroads into the average investor’s consciousness. By the mid-1990s, however, Vanguard had initiated a wide variety of index funds and was steadily gaining ground as it won assets away from traditional, actively managed funds. And what good timing. During the 1990s, index funds handily beat almost every actively managed stock fund.
By 2000, the momentum toward index investing seemed unstoppable. But those who piled into index funds and have stubbornly insisted it’s the only rational way to invest have experienced pitiful results ever since. Since December 31, 1999, the average annual total return for the S&P 500 index, including dividends, has been a motley 0.55 percent, much worse than cash.
What’s wrong?
In The Wall Street Journal, Malkiel recently reviewed a book called Models Behaving Badly by Emanuel Derman, a Ph.D. physicist and former head of quantitative trading at Goldman Sachs. The model Derman especially takes issue with is the EMM, citing the inappropriateness of its statistical assumptions and its failure to reflect the complexity of real-world investing. Of course, Malkiel defends the critical assumptions of EMM, reasserting that it is, as he says, “well-nigh impossible” for investors to be sure whether prices are too high or too low.
What Malkiel still doesn’t get is what we’ve learned through research and investigation in finance and psychology in the ensuing five decades since the publication of his seminal work.
First consider human behavior. The stock market, like all markets, is but a meeting place for the exchange of human opinions. X believes $185 in cash is worth more than his share of IBM stock, while Y would much rather hold IBM stock than the $185 cash in his pocket, so X and Y happily exchange their holdings. For both investors, the decision to make the exchange may be rational, but is highly likely to be emotional or simply irrational.
In 1979, just a few years after Random Walk appeared, psychologists Daniel Kahneman and Amos Tversky published a paper on economic decision making that’s proven to be a seminal event in the development of a field now known as “behavioral finance.” What a numerous and growing body of investigators has documented is that human decision making process is predictably flawed. If that’s so, then why is it impossible to determine if stock prices are too high or too low?
Although behavioral finance theory and practical results haven’t been completely connected yet and may never be, we don’t necessarily need to have that connection to act on powerful empirical evidence suggesting that certain categories of stocks are persistently overvalued. Let’s look at two.
Regular readers know I’ve made a career from building portfolios of stocks that regularly grow their dividends. Ned Davis Research in Venice, Fla., has maintained a long-term data series of stock returns by dividend policy. Hands down, stocks of companies that regularly increase their dividends have outperformed all other categories, while returns for stocks of companies that pay no dividend are barely above zero. Here are the annualized returns since 1972 by dividend policy:
Dividend growers: 9.4 percent
Dividend payer/no change: +7 percent
Dividend cutters: -0.9 percent
Non-dividend payers: +1.4 percent
These results wouldn’t be possible unless dividend paying and especially dividend growing stocks were typically priced below value and non-dividend paying stocks priced above value. In the face of this evidence, is it rational to put one’s money in an index fund that includes stocks that pay no dividends?
Here’s a second, readily observable anomaly between price and value. Investment analysts use price volatility as a proxy for investment risk and typically assert that, to generate greater returns, one must take more risk. Real-world evidence says it isn’t so. In a 2011 Financial Analysts Journal article by Baker, Bradley and Wurgler, the authors present results from their analysis of stock returns by volatility over the past 45 years. The bottom line: Low-volatility (lower risk) stocks outperformed higher-volatility (high risk) stocks by about 5 percent annually, results that are again impossible to square with an EMM that asserts investors cannot tell whether given stocks are priced too high or low.
Perhaps an inherent human penchant to view risk as having its own reward can explain why an otherwise rational investor would invest in high-risk stocks if his stated goal is making money. But we don’t need to be academics in the field of behavioral finance to recognize the opportunity to improve our returns by buying only lower volatility stocks and letting index fund investors put significant money into high volatility and non-dividend paying stocks.
