JumboCash: Think you can pick stocks? Think again

When people think about investing, they often believe that managing their money requires the ability to “pick stocks.” Finance-related student organizations also promote this approach by making “stock pitches” the focal point of the club experience. Although there are merits to analyzing individual stocks in-depth, modern financial theory suggests a different approach to investing in equities. 

Eugene Fama, a Tufts alumus (A'60) widely regarded as the “father of modern finance,” developed the efficient market hypothesis. His research suggests that stock prices reflect all publicly available information, meaning that securities trade at their fair value at any moment in time. 

Based on his hypothesis, it is impossible for investors to consistently achieve higher risk-adjusted returns than the market — in order to achieve higher returns, investors would need to take higher risks. Therefore, technical research, stock picking and trying to find undervalued assets would be a waste of time, as the market constantly incorporates new information into prices.

Studies that test the consistency of outperformance by actively managed funds show that active management has a poor track record. A recent study by Standard & Poors tested the performance persistence of U.S. equity funds over consecutive 12-month periods, from 2014 to 2018. They found that of the 571 actively managed funds that began in the top quartile of performance in 2014, only .18% of the funds remained in the top quartile by the end of the fifth year. 

Given the proven lack of long-term manager outperformance, it is difficult to say whether any short term manager success is due to skill, or if it is simply luck. And, if managers had special stock-picking ability, why were they unable to repeatedly capitalize on their expertise?

Fama’s theory has been met with heated debate, especially among behavioral economists. Detractors of the theory argue that investing is largely driven by psychological biases and not rational behavior that would lead to a fairly priced security. They argue that in speculative bubbles, investors cannot be acting rationally, meaning asset prices are not trading at their fair value. 

Fama’s main defense to behavioral economists is based on how he views bubbles themselves. If such an egregious mispricing occurs at any given point in, then why aren’t investors correctly predicting and profiting from the market’s error? It is only in hindsight that investors understand that their future expectations were wrong. As we saw in the report on active manager performance, even the financial experts managing equity funds cannot consistently foresee events and “beat the market.”

Now, what does the efficient market hypothesis mean in terms of your own investment strategy? Fama recommends investing in low-fee index funds that mirror the stock market. Owning a fund that passively tracks the stock market tends to be cheaper than paying a high fee to a manager who charges for their alleged stock market expertise. According to the efficient market hypothesis, it wouldn’t make sense to pay higher fees for actively managed funds that can’t consistently beat the market, when you can effectively own the market at a very low cost.

The idea of investing in the next Microsoft can seem enticing, but according to the efficient market hypothesis, trying to pick such a stock is a fruitless exercise.