A theorem of "folk finance" is that it is easy to beat the return of an asset market. A corrollary is that an investor can be informed by paying attention to claims made by others that they have in fact done this.
This is nonsense. Nonetheless it is a fairly popular belief.
Mahalanobis summarizes a paper that looks at this. Understanding the body of the post probably requires some Ph.D. finance classes, so let me translate.
The example at the bottom of the page is built around a hypothetical manager who can consistently beat the market by 3% (that would be an enormous advantage, and it isn't at all clear that anyone has ever done that well). Yet, you can only be 65% sure that this manager will beat the market over the next 25 years.
How is this so? The reason is that the volatility of the market and individual portfolios is so large that one lucky or unlucky year is enough to screw things up.
What does this mean for the casual investor who may pay attention to advertisements that claim that such-and-such a manager has beaten the market for (say) the last 5 years? It means that the odds are 51/49 or so that this manager is above average. On the bright side, this is a bit better than the 50/50 chance that any manager you find in the yellow pages (or even with a poster stapled to a telephone pole) is above average.
This doesn't inspire a lot of confidence. Of course, if you think about investment managers though ... they spend an awful lot of time trying to inspire your confidence. Get a clue - they have too!
P.S. This economist-who-does-finance-too's inside view is that a big difference between economics and finance Ph.D.'s is that the former accept that they can't beat the market, and the latter think that no one but them can beat the market.
All finance professors are plagued by the believe that markets are efficient, and efficiency means no one can beat the market.
However, this is not true. It's quite easy to beat the market through contrarian investing. I've beat the market every year since I started seriously playing it in 2000.
Posted by: Half Sigma | May 08, 2005 at 10:19 AM
It's not that it's necessarily that finance professors believe that beating the market is impossible, it's just that it's difficult to distinguish between beating the market because of skill versus beating the market because of luck. While half sigma might not attribute his or her returns to good luck, a lot of people often attribute poor returns to bad luck. The luck has to run both ways.
Posted by: john top | May 10, 2005 at 11:11 AM
To be honest, I most associate this view with not one, but three finance professors where the careers of John Top and myself intersected.
Posted by: Dave Tufte | May 10, 2005 at 01:42 PM