It's an idea derived from research that resulted a Nobel Prize for Economics. It's the foundation upon which John Bogle built one of the two largest mutual fund companies in the world. It's practically a creed for small investors.
And it's a course that would destroy the markets if everyone believed in it.
If you have at least a casual knowledge of the market, you're familiar with the adage: You can't beat the market. Even before researchers studied the figures in the 1960s, the truth wasn't hard to discern -- most people lack the ability to outperform market averages over a sustained period. Not professional money managers. Not your local investment club members. Not your relative who happened to make a fortune holding onto General Electric stock for 20 years. And probably not you.
Most people have long known this on some level, and after economic studies finally confirmed it (and started "efficient market" theorists like William Sharpe and Harry Markowitz on the road to Nobels), companies like Bogle's Vanguard Group built an empire on selling index investing to the masses. By replicating the broad market instead of cherry-picking it, individuals could reduce their risk and save money. And they didn't have to think anymore -- just put in the cash and leave it alone. It was a deal that retail investors found difficult to refuse; according to Standard & Poor's, more than $1 trillion is currently indexed to the most popular benchmark for large cap stocks, the S&P 500.
Yet even more money is "actively-managed" in some way. Despite admonitions to investors from the likes of The Motley Fool and warnings from books with titles such as The Great Mutual Fund Trap (co-written by a guest on this week's program, Gary Gensler), the 17 largest active funds oversaw than $434 billion in assets at the end of last year, and there are thousands more of these investing vehicles. Fidelity Magellan has been the world's largest mutual fund of any sort since the 1980s, despite the fact that in recent years its performance is hardly distinguishable from the broad market. Magellan investors are paying active management fees for nothing more than index-like performance:
Morningstar recently described the Magellan fund as the top destroyer of wealth in 2002. It's enough to raise a question of who the truly passive investors are.
The popular financial site Motley Fool argues that you can do your own research to find worthy stocks. But individual investors aren't any better at stock-picking than the pros. In their now-legendary study of more than 64,000 discount brokerage customers in the 1990s, University of California at Davis economists Brad Barber and Terry Odean found that the average retail investor's stock picks returned 1.8 percentage points less than the overall market, once brokerage fees were factored in. And the more frequently people traded, the worse they did -- the 12,000 customers who did the most trading averaged a net return of 10 percent a year, while those who traded the least gained 17.5 percent.
Why do people bother trying to beat the market? It's not rational. And that's a good thing, because if the market were completely rational, no one would make money.
If investors were cold, calculating machines, the market would be predictable and obvious, but it isn't. Even the weather is easier to forecast, and in fact, storm systems are the financial markets' opposite; meteorologists are generally on-target in the short-term -- 5 days or less -- while the stock exchange is practically impossible to project with any accuracy for a period of less than 5 years.
It's the ebb and flow of emotion, rather than reason, that is measured in stock charts. Behavioral economists have been arguing that point for decades, and they're finally winning recognition -- one of the godfathers of the field, Daniel Kahneman, shared last year's Nobel Prize for economics. Then again, their viewpoint may have received all the support it needs from just two extraordinarily successful investors: Warren Buffett and George Soros.
The two men work in vastly different realms; Soros made his name as one of the greatest currency traders of all time, while Buffett became legendary for his record in buying and holding stocks. But Soros and Buffett share two traits: they're really good at what they do; and they scoff at the idea of a rational market. In an interview last year on Wall $treet Week with FORTUNE's Sept. 20 program, Soros reiterated his long-held view that psychology is a fundamental trait of financial markets: "I believe that markets are reflexive, and market sentiment is one of the fundamentals that you have to take into account."
And Buffett, a disciple of value investing guru Benjamin Graham, directly blasted efficient market theorists in his 1988 letter to Berkshire Hathaway shareholders:
"Observing correctly that the market was frequently efficient, they went on to conclude incorrectly that it was always efficient. The difference between these propositions is night and day. ... The disservice done students and gullible investment professionals who have swallowed EMT (efficient markets theory) has been an extraordinary service to us and other followers of Graham. In any sort of a contest -- financial, mental, or physical -- it’s an enormous advantage to have opponents who have been taught that it’s useless to even try. From a selfish point of view, Grahamites should probably endow chairs to ensure the perpetual teaching of EMT."
Buffett's own performance is the linchpin of his argument against efficient markets theory: "In my opinion, the continuous 63-year arbitrage experience of Graham-Newman Corp. Buffett Partnership, and Berkshire illustrates just how foolish EMT is."
It's hard to dispute his point -- we know the market can be beaten, because people do it. By definition, an average requires someone on the upper side of the curve.
Ultimately, that's what drives stocks. People witness success and believe they can emulate it. They saw Peter Lynch's Magellan run in the 1980s and put even more money into Fidelity's hands. The skeptical cliche calls it chasing performance, but how else to judge winners, if not by past record? (Never mind that the money has kept flowing in long after Lynch left; Fidelity picked one winning fund manager, why can't it pick another? Or so the thinking goes)
And if no one believed in their own ability (or at least the ability of active managers) there would be no liquidity in the market. Or put cynically, Wall Street needs suckers who wrongly think they can beat the market, because someone has to buy and sell stocks at the wrong time if the Buffetts and Lynches of the world are going to make money. And the reality is that there are a lot more losers than Buffetts.
John Bogle basically argues that you can avoid being that loser by not trying too hard -- mimic an index and let the market take care of itself. As far as stocks go, it's probably a good theory for individuals who have the wherewithal to wait out bear markets.
But you should hope your neighbor isn't listening. Someone has to keep the stock exchanges greased.
-- Sergio G. Non is the online editor of Wall $treet Week with FORTUNE.
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