Can you ever be smarter than the market as a whole?
After all, aren't some stocks ignored, bargain-priced or just plain misunderstood? If you're Prof. Eugene Fama, one of the fathers of the Efficient Market Theory, the answer is no. You're better off investing most or all of your portfolio in index funds.
Fama's work in finance has won him a Nobel Prize in economics and is the bedrock of the school of passive investing. Based at the University of Chicago's Booth School of Business, he's often a scold of active management.
If Fama's position holds true -- there's been vigorous debate over the years -- then it makes little sense to try to play "factors" in the market, time the mood of investors or even buy individual stocks.
When I saw Fama speak on June 13 at the CFA Society Chicago, his comments were as sharp as scalpels when asked about various forms of active management. He just doesn't see much use for managers who either try to time the market or find stocks that traders think are mispriced.
In Efficent Market Theory, the foundation of passive investing, the market knows all and sees all. All available information is out there, so a stock is priced "correctly" nearly all of the time. And even in an age of computer-based, high-frequency trading, individual investors don't stand a chance of getting a better price. Note: The 2008 meltdown was a chink in the armor of the theory.
“Portfolio management is not a full-time job,” Fama told the standing-room-only crowd, most of whom were engaged in the business of active portfolio management. Fama suggested that money managers even focus on value-added services such as tax and estate planning to survive in the changing industry.
What about picking times to be in and out of the market when stocks are either too pricey or bargains?
"Forget timing factors," Fama retorted with his sly smile. "That's ridiculous. Timing should basically be thrown out the window."
"There's no question on whether active management is better. It's a zero-sum game. It's arithmetic. After costs, it's not controversial. Investors are always better off going passive, even if you can pick a [winning money] manager. Why pay people to do things they can't do?"
Another reason why passive investing is the best mode for most investors? You're just not going to be able to beat "algorithmic" traders, firms that use high-speed computer systems that buy and sell at lightning speed.
Do you honestly think that you can beat the robots and do so at the lowest-possible cost? It can't be done. And if you manage to make a profit, Fama says most of the time it's due to luck, not skill (that's applies to professional managers as well).
What does all of this boil down to? In Fama's view, individuals should focus on saving as much as they can and determine what kind of risk is right for them.
Of course, you can do both of these things with passive index fund portfolios, which should be staples of your 401(k) or IRAs. Just keep in mind that risk is more important than returns.
"The probability that you can lose money never goes away," Fama adds. "It's the nature of the beast."
