Malkiel on Beating the Market

"Telling people you cannot beat the market is like telling a six-year-old that Santa Claus doesn't exist. The six-year-old doesn't want to believe it. Neither do people on Wall Street." - Burton Malkiel, Princeton University professor and author of A Random Walk Down Wall Street and The Elements of Investing.

I highly recommend The Elements of Investing. I routinely give this book out to those who are interested in learning more about the keys to successful long term investing.

Analysts Get it Wrong - Most of the Time

Ever wondered how effective equity analysts are in accurately predicting the prices of the stocks they monitor? Bloomberg reports that the prices of the stocks in the S&P500 that received the most "buy" recommendations from analysts rose 73% on average since March of 2009.

However, the stocks with the fewest "buy" recommendations gained 165%. For perspective, the S&P500 index has gained 88% since hitting a low of 1,271.50 on March 9, 2009.

Bloomberg found that the companies with the most "buy" ratings gained 8.7% in 2010. The stocks with the fewest "buy" ratings rose 20%.

What can we make of this? It is very difficult to predict what will happen with the market, much less individual companies. Analysts know more about the companies they follow than anyone except the senior management of the companies themselves. Even then they are not very good at predicting price movement. In addition, we may wonder about the incentives they may have to issue ratings.

Once again we turn to low-cost passive investing as the most intelligent approach for long term investors.

Hedge Funds Underperform and Overcharge

I have long been suspicious of hedge funds. These privately managed funds are very lightly regulated. They are typically very secretive and unwilling to explain their investing methodologies. They charge very high fees that are typically 2% of funds under management and 20% of profits.

Hedge Fund Research reported that since the start of 2009, the average performance of hedge funds has trailed the return of the Standard & Poor's 500 index in six out of eight quarters. Hedge funds were up 10.4% on average in 2010 compared with a 15% gain for the Standard & Poor's 500 index, including dividends reinvested. (Source: The Wall Street Journal).

This is only part of the story, however. Most hedge funds pursue strategies that are risky. So, while we don't know for certain, it is very likely that in addition to underperforming the market, most hedge funds carried more risk than the market itself.

Investors should be very wary of hedge funds.

The January Effect

The stock market is off to a very nice start in the first few days of the New Year. Some market technicians attribute this to the “January Effect” which describes a phenomenon in which stocks rally in the first few weeks of a new year. The buying is often attributed to investors who redeploy cash that was created from selling losing stocks in December. The selling is done to create tax losses that may be used to offset capital gains.

Given that investors often place the bulk of their savings in qualified retirement plans (IRAs, 401(k)s, 403(b)s, etc), one may wonder about the extent to which this “tax loss harvesting” actually occurs today.

It turns out that small cap stocks seem to benefit from the January Effect more than other stocks. Mark Hulbert, writing for Market Watch, points out that in all Januarys since 1926, small cap stocks have beaten large cap stocks by an average of 7%. The performance of large cap stocks in January is statistically indistinguishable from their performance during the other 11 months of the year.

The January Effect is a “market anomaly” - abnormal performance within the stock market that is contrary to the principles of an “efficient market.” Intelligent investors are very skeptical of such anomalies. If they were persistent, then smart investors would game the system and exploit them. This very action would eliminate the anomaly.