Index funds, still the way to go

If the market is efficient then without an information advantage (non-public information) you can’t expect to beat the market and thus index funds are a good way for the average investor to invest. Behavioral finance has put some dents in efficient markets theory but just because a market is inefficient that doesn’t mean that beating the market is easy. Even if you knew that firm X was way overvalued, for example, shorting the stock would expose you to great risk – the price could become irrationally higher before the bubble bursts, unexpected events could increase the fundamental value to match the bubble, your capital could run out before the price drops and, of course, you could be wrong.

When you hear the term inefficient market don’t think $500 bills lying on the sidewalk, think $500 bills swirling around you in a vortex of wind…at night. Inefficiency is out there but it’s hard to find.

The bottom line remains that most professional money managers don’t beat the market. Here’s a recent reminder from James Glassman of this fact:

Charles Allmon points out that last year the poorly rated stocks of many research services outperformed their highly rated stocks. For example, Standard & Poor’s one-star stocks returned 57 percent while its five-star stocks returned 43 percent. Merrill Lynch’s sell-rated stocks returned 46 percent while its buy-rated stocks returned 30 percent. Schwab’s F-rated stocks returned 70 percent while its A-rated stocks returned 66 percent. The biggest discrepancy came with Value Line, whose 5-rated stocks (the 100 companies with, supposedly, the worst prospects for the year ahead) returned an incredible 90 percent while the 1-rated stocks (the top prospects) returned 40 percent.