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What Malkiel’s Random Walk Got Wrong about Pricing Efficiency

There’s many different trains of thought when it comes to the stock market. Among those is the idea by Burton Malkiel that you can’t beat the market—because prices move around like a random walk and that stocks are already efficiently priced.

Malkiel’s work has been both praised and criticized by many. He is a big proponent of the efficient market hypothesis (EMH), which states that the market is efficient and stocks are always correctly priced based on the information available.

random walk

EMH is without a doubt a hotly debated topic in economics. On the one side you have very highly educated people who support EMH. Academics, many who are from the University of Chicago, who are recognized for their studies, research, and dissertations and hold many prestigious awards and positions.

On the other side is the group who opposes EMH. It comprises of individual stock investors, many who run their own funds or invest with other people’s money. A special group of these investors, clustered from the Columbia School of Business, have public track records of handily beating the market for decades. Many investors from this school of thought are both respected as businessmen and extremely wealthy—to the tune of billions.

This special group, dubbed the SuperInvestors of Graham and Dodd by Warren Buffett, are known as value investors and they believe that the market creates inefficiencies—causing stocks to trade in ranges outside of their real value. Emotions such as optimism and pessimism influence stocks one way or the other, creating opportunities in stocks that are undervalued.

Malkiel claims that there’s no way for the average investor to reliably gain an information edge in today’s age, and that stocks efficiently move up or down as new information on business results comes out.

He also claims you can’t beat the market and that past track records of successful managers are just outliers. Malkiel uses the following analogy to explain why.

A large group of monkeys all flip a coin. Heads is a winner, tails is a loser. As the coin flip results move around in a random walk, there’s a likely probability that some monkeys will flip consecutive winners as this experiment plays out. As this luck continues, other monkeys seek advice and try to emulate the winning monkeys—much like we see on Wall Street today.

Warren Buffett arguably disproved this analogy in his SuperInvestors speech. He said something along the lines of… if every winning monkey comes from the same business school (The Columbia School of Business), you should start to question the idea that it’s a random walk and maybe investigate what kind of coin they are using.

Interestingly, Malkiel glossed over this valid critique and refused to address it.

I’m not here to throw dirt on Burton Malkiel and his work. In fact I respect much of his contributions to the world of economics, and it turns out we agree on several things.

1) A reason Malkiel advises investing in index ETF funds over mutual funds is because of the high expense ratio that is attached to almost all mutual funds. There are different fee structures for various types of funds, but those who are actively managed by a person are all but certain to be more expensive to the investor than one passively managed.

A mutual fund can charge 1 or 2% in fees to the investor just at the onset. This might not seem like much, but when you are talking about the life or career of an investor that percentage point compounds to a make a serious difference. If you’re going to invest in a fund, just the aspect of fees makes an index ETF far more attractive than a mutual fund.

2) Malkiel takes this a step further with research about the average mutual fund manager underperforming the market. If the professionals can’t do it, his logic is that the average investor can’t do it either. So he takes these findings to conclude that EMH is valid and you can’t beat the market.

Of course, I’m not going to disagree with facts. The data and studies about underperforming mutual fund managers are there. If you put a gun to my head and forced me to choose between only a mutual fund or an index fund, I’d choose the index fund because of these two distinct advantages. No question.

But…

I take exception to the idea that since a majority of mutual fund managers can’t beat the market, that markets are efficient and can’t be beat. It’s not that there aren’t exceptions to the rule—and Malkiel never argued that. After all, some “monkeys” are going to get better results. However, he concludes that these institutional investors—who have vastly more informational resources and capital than the individual investor—all underperform on average, so the average stock picker should expect the same.

He doesn’t consider or acknowledge the real reason why these institutional investors underperform (and there’s several). Let’s start with the most basic factor. 

1.

Mutual fund managers and their clients don’t have financial interests aligned. An investor into the fund makes the most money when the fund earns fantastic returns over a long time period. On the contrary, the funds themselves make the most profit not from returns—but assets under management.

This means that investment funds are primarily more concerned with marketing than long term performance. After all, follow the financial incentives to get the complete picture.

A greater concern in attracting new clients means that fund managers would be best served to dress their portfolio with the stocks that most of the public would like to own, rather than buying stocks that will actually produce better [long term] returns.

I’ll give you a fine example of this.

It doesn’t take a PhD or deep understanding into the science of nutrition to know these 2 facts: it’s easier to limit calorie intake than to burn calories, and having a calorie deficit will result in fat loss.

I know this to be true because I lost 25 pounds from simply measuring most every calorie and eating at a deficit. I didn’t change my exercise routine, only the diet. I ate chips, cheese, and hot dogs regularly. I trusted the basic facts of science about calories, and it worked. It took me 6 months to do this by the way. I got predictable and consistent results, at a rate of 1 lb per week.

But where’s the money in fat loss?

It’s in the fitness industry. Even though it’s scientifically proven to be much easier to eat less rather than burn calories, the general consensus seems to be that exercise [particularly cardio] is the way to go. The crowd catches on to a trend and then the dollars pour in.

First it was P90X, then the Atkins diet, and now we have organic foods, Zumba, Crossfit, “boot camps”… the list goes on. But the public starts a demand, and then businessmen go to work creating products to fill those needs.

That reality of marketing is no different for these mutual funds. Investors who get excited about Amazon, see Netflix as the future, and want exposure in Biotech companies will likely pick the fund that holds these stocks in their portfolio—regardless of how expensive the stock is and even if the trade has a good chance of ending in a loss.

2.

Malkiel argued that fund managers have financial incentives to perform well, so they must be doing everything they can for better performance. This may be true, but we also don’t know to what extent they also receive financial incentives for attracting more assets under management.

A big problem with these financial incentives for performance is that many mutual funds desire big short term gains. This is another way to dress up the portfolio by attaching big return numbers next to their list of positions. A fund manager is more likely to be compensated with lucrative bonuses for hitting certain short term performance numbers, which may influence him to take on more risk.

Heads of these funds may also rationalize seeking short term gains at the sacrifice of long term outperformance because many of their clients tend to jump ship when a fund performs poorly in the short term. Which again reinforces the conflict of interest, but that’s not the point.

The reality for many mutual funds is that short term is prioritized over long term, and marketing pull is prioritized over long term gains.

3.

You also have to consider the personal factor here. Besides the point that fund managers are human and just as irrational and emotional than the rest of us, they are also people showing up to a job that they probably don’t want to get fired from. How do you get fired in this business?

It’s a somewhat interesting dichotomy. A fund could lose 20% in a year, but investors wouldn’t care too much if the general market also lost 20%. However, losing 5% when the S&P gained 2% in a year could spell doom and the unemployment line for a fund manager.

A great way to limit earning returns much lower than the crowd is to actually invest like the crowd. Many funds do this on purpose, over diversifying so much that it may as well be an index fund.

The three major factors here that differentiate an institutional investor from an individual investor should lead us to one conclusion: they are not the same. So the results from one type of investor, say the institutional, can’t determine the results of another type—like an individual. It’s apples to oranges.

At the very least, the differing influences on mutual fund performance should create doubt about the market being completely efficient.

Institutional investors make up a large portion of the market. According to Seth Klarman in Margin of Safety, it had reached 45% by 1990. If so much capital is affecting stock prices like this for reasons explained above, then large sections of the market are at risk of being priced inefficiently.

Since writing A Random Walk on Wall Street, Malkiel has seen other critics poke at the efficient market hypothesis. Wishing to address some of these, he recently wrote a paper with his rebuttals.

Some of what he covered is beyond the scope of this article. I have basic disagreements of how Malkiel sees efficient pricing even towards the tail ends of bull and bear markets. Also, he tried to refute the validity of smaller stocks outperforming larger stocks by calling them riskier—because they had higher beta. The idea of risk as beta is another poisonous academic idea for the individual investor. I digress.

Malkiel had some noticeable qualms with valuations, particularly:

  • Price to Earnings Ratio
  • High Dividend Yield
  • Price to Book Ratio

His attack on P/E and dividend yield looked at performance after buying just low P/E stocks or just high dividend yield stocks and comparing it to the market average. He found that these strategies would’ve underperformed, thus implying that these ratios aren’t very useful when all data is available and instantly analyzed by the entire market.

A second point was that if investors had strictly utilized a strategy where they only bought when the market average for P/E was below a certain point (I believe enough to be considered an undervalued market), then the investor would’ve missed out on more than 12% a year in returns.

It’s true that value investors use ratios like P/E and dividend as part of their analysis. But using these to disqualify buying at certain times isn’t what most value investors do. Benjamin Graham, the “father of value investing”, always advocated a dollar cost averaging strategy and had a strong aversion to the concept of trying to time the market.

With the low price to book ratio, Malkiel argued that such a ratio could signal a good buying opportunity, but also could indicate a company in financial distress.

Again, that’s a fact that I won’t question. But nowhere in any value investing literature does it say to focus a valuation on one metric. In fact, the central premise behind my whole stock picking strategy is to identify companies that are value traps by doing the exact opposite of focusing on a single metric.

efficient market hypothesis

If I really narrow down my biggest gripe with the efficient market hypothesis, it’s the claim that stock prices reflect all available information, so valuations can’t provide investors with stable out performance.

The whole idea behind this claim is fundamentally flawed. It doesn’t take much logic at all to see that this is the case.

Look…

The market doesn’t have a standard valuation process to value stocks. You’ll rarely find two investors who use the exact same intrinsic value analysis.

So if there’s no even playing field—then some metrics are inevitably more important to some investors than others. Which means that two investors looking at the same information will interpret how much it changes a stock’s value differently.

How is this simple point not obvious?

It absolutely confounds me how in a market that has a variety of different strategies—indexing, growth investing, value investing, technical analysis, dividend growth investing, energy and precious metal speculation—anyone could believe that public information is perceived the same way by the crowd.

I mean, with a substantial portion of the market coming from institutional investors, how much of a stock’s success is really due to its business results and not by how many times it’s the hot topic on CNBC?

The disproportionate amount of stocks that have extremely high valuations but can’t even turn an annual profit proves on its own that the market isn’t efficiently priced.

And if you disagree, you can’t argue that this disproportionate amount at least proves that the crowd has a very different valuation calculation than most value investors, providing opportunity to the latter.

As if to further make his point, Malkiel shared some data about a large group of “value” funds also underperforming the market. He again ignores the bigger conclusion from that data—that the interests of long term shareholders in the company don’t align with what’s best for the fund.

Which brings me to my final problem with this whole random walk thing. What’s not talked about much is the financial incentives behind the guys who have been vocally pushing indexing.

Two of the biggest indexing proponents, Burton Malkiel and Jack Bogle, have been part of Vanguard at one time. Vanguard now has one of the largest amount of assets into their funds—the index funds being one of the most popular. Bogle founded Vanguard and Malkiel was a former director there. Malkiel’s new company offers a variety of funds like Vanguard, with each one of them being an index fund.

It’s just something to notice. At the risk of living in a glass house, I’ll also admit that my financial incentive as a value investing teacher makes me look at EMH with a certain bias.

There’s nothing morally or legally wrong with what they are doing. In fact I’ll agree that the majority of investors should be just buying an index fund for the long term… because the majority of investors don’t have enough desire to learn about successful strategies. Internalizing the meaning of the numbers just isn’t for everyone. Neither is the fortitude to go against the crowd and trust your analysis.

But understanding the potential conflict of interest that Malkiel may have with you as an individual stock investor may take these highly regarded EMH achievements off the pedestal a little bit.

It’s sound and simple logic. The efficient market hypothesis is built on weak ground, failing to consider big picture ideas. Prices don’t move in a random walk. In fact, they likely move upwards as a business grows, but do so at widely varying rates. As new stock data comes out each day, remember…

Beauty is in the eye of the beholder.