Here equily co-founder Helen Lawton, reviews some of the academic evidence that underpins equily’s approach to investing.
There are decades of research in both academia and the investment industry that find active managers cannot consistently beat the market. Costs and investor behaviour also matter.
Efficient Market Hypothesis (EMH)
The Efficient Market Hypothesis (EMH) is an economic theory postulating that current market prices reflect the collective estimate of all investors based on the information that is currently available, and available to everyone. It is not possible for an investor to accurately predict future prices because they do not have access to inside information that is unknown to other investors. It is important not to take the EMH too seriously (and it has certainly been debated and challenged many times – see Shiller’s article below) but it is right enough of the time for it to be a reasonable basis for using passive rather than active investment management.
Radical Uncertainty
It is also worth acknowledging that economics does not cope well with what economists John Kay and Mervyn King call “radical uncertainty” — this is uncertainty not just about what might happen, but the kinds of things that might happen.
See the book “Radical Uncertainty: Decision-making for an unknowable future” by John Kay and Mervyn King (2020) for a fascinating exploration:
Academic Evidence: Active vs Passive Investing
1.“The case for low-cost index-fund investing” by Plagge, J-C., Rowley, J.J., Vanguard Research, March 2022
From Abstract: “This paper presents the case for low-cost index-fund investing by reviewing the main drivers of its efficacy. These include the zero-sum game theory, the effect of costs and the difficulty of finding persistent outperformance among active managers.’
2. “Reflections on the Efficient Market Hypothesis: 30 Years later” by Malkiel, B., Financial Review, 2005
In this paper, Malkiel finds that over a period of 44 years (1970–2004), 65 out of 139 actively managed funds underperformed their index by 1% or more a year and only four outperformed by 2% a year. In the concluding comments Malkiel says:
“The evidence is overwhelming that active equity management is, in the words of Ellis (1998), a “loser’s game.” Switching from security to security accomplishes nothing but to increase transactions costs and harm performance. Thus, even if markets are less than fully efficient, indexing is likely to produce higher rates of return than active portfolio management. Both individual and institutional investors will be well served to employ indexing for, at the very least, the core of their equity portfolio.”
http://www.e-m-h.org/Malkiel2005.pdf
3. “From Efficient Markets Theory to Behavioural Finance” by Shiller, R., J., Journal of Economic Perspectives, Volume 17 Number 1, Winter 2003
In this article, Shiller argues that irrational price changes do occur in financial markets, and the Efficient Markets Hypothesis is unable to reconcile such price changes. Shiller argues that behavioural finance must be incorporated into new models of financial markets. He warns that we should “distance ourselves from the presumption that financial markets always work well and that price changes always reflect genuine information.”
http://www.econ.yale.edu/~shiller/pubs/p1055.pdf
4. “The Efficient Market Hypothesis and Its Critics” Malkiel, B.G., Journal of Economic Perspectives, Volume 17 Number 1, Winter 2003
Abstract: “Revolutions often spawn counterrevolutions and the efficient market hypothesis in finance is no exception. The intellectual dominance of the efficient-market revolution has more been challenged by economists who stress psychological and behaviorial elements of stock-price determination and by econometricians who argue that stock returns are, to a considerable extent, predictable. This survey examines the attacks on the efficient market hypothesis and the relationship between predictability and efficiency. I conclude that our stock markets are more efficient and less predictable than many recent academic papers would have us believe.”
https://www.princeton.edu/~ceps/workingpapers/91malkiel.pdf
5. “Asset Allocation Dynamics and Pension Fund Performance” by Blake, D., Lehmann, B. N., & Timmermann, A., Journal of Business, Volume 72 Number 4, October 1999
The authors studied a set of UK pension funds and found returns are determined by asset allocation not individual stock selection by active managers. The authors found the typical return from individual stock selection and market timing was actually negative!
https://www.jstor.org/stable/10.1086/209623?seq=4
6. “Determinants of Portfolio Performance” Brinson, G.P., Hood, L.R. and Beebower, G.L., Financial Analysts Journal, Volume 51 Issue 1, January 1995
From Abstract: The authors found that although “investment strategy” (defined by the authors as market timing i.e. over-or underweighting within an asset class, plus security selection) can result in “significant returns,” these are dwarfed by the return contribution from “investment policy”, defined by the authors as the “selection of asset classes and their normal weights.”
7. “The Arithmetic of Active Management.” Sharpe, W. F., Financial Analysts Journal, Volume 47 Number 1, January/February 1991
Quotes from Article:
“Properly measured, the average actively managed dollar must underperform the average passively
managed dollar, net of costs.”“It is perfectly possible for some active managers to beat their passive brethren, even after costs. Such
managers must, of course, manage a minority share of the actively managed dollars within the market in
question.”
https://web.stanford.edu/~wfsharpe/art/active/active.htm
8. “Prospect Theory: An Analysis of Decision Under Risk” Kahneman, D., Tversky, A., Econometrica, Volume 47, Number 2, March 1979
Prospect theory is part of behavioural economics and describes how people’s decisions are influenced by their attitudes towards risk, uncertainty, gains and losses. It argues that people value gains and losses differently and are more influenced by the possibility of a loss than the prospect of an equivalent gain. People are more upset by losses than they are pleased by equivalent gains. This is a key human bias known as “loss aversion”.
Prospect theory also argues that people view gains and losses relative to a reference point (usually their current situation). People are more likely to take risks to avoid losses than they are to make gains. This might explain why investors tending to avoid selling investments that have already made a loss.
Finally, prospect theory argues that people find it hard to assess probabilities accurately, and they tend to overestimate the possibility of low-probability outcomes and underestimate the possibility of high probability outcomes.
https://www.jstor.org/stable/1914185
9. “Efficient Capital Markets: A Review of Theory and Empirical Work” by Fama, E., Journal of Finance, Volume 25 Number 2, May 1970
In this paper, Fama concludes that, with a few exceptions, the Efficient Markets Hypothesis stands up well. Fama argues that although capital markets are far from perfect, they do a good job of fairly pricing in all available information and investor expectations about publicly traded securities.
10. “Portfolio Selection” Markowitz, H., The Journal of Finance, Volume 7 Number 1, March 1952
In this article Harry Markowitz develops his groundbreaking theory of portfolio choice, known today as Modern Portfolio Theory (MPT). In 1990 Markowitz was awarded a Nobel Prize in Economics for his theory of portfolio choice, which emphases portfolio diversification and overall portfolio risk and return, rather than investors just focusing on the performance of individual investments.
Risks for individual stocks consist of both “systematic risk” (these are market risks that cannot be diversified away) and “unsystematic risks”. Unsystemic risks are associated with individual investments and can be diversified away by increasing the number of investments in a portfolio. Hence a well diversified portfolio should be less risky than one concentrated in a small number of investments.
The cornerstone of MPT is that the expected risk and return of an individual investment is not as important as the composition of the investor’s entire portfolio. In MPT, it is important to diversify a portfolio by adding individual investments which have lower “covariances”, meaning each investment added to the portfolio does not behave in the same way as the other investments in the portfolio. This reduces overall portfolio risk, even if individually, the investments are higher risk.
https://onlinelibrary.wiley.com/doi/abs/10.1111/j.1540-6261.1952.tb01525.x
Please note, when investing, your capital is at risk, and returns are uncertain. The information in these blog posts does not constitute financial advice and should not be considered as such.
Helen Lawton
equily co-founder
A Cambridge graduate, Helen worked at the Bank of England for ten years in various roles, including working for the now-Governor, Andrew Bailey. Helen worked in the area of the Bank responsible for banknotes, as an economist working for the Monetary Policy Committee, and in the aftermath of the 2008 global financial crisis, she worked in the area of the Bank responsible for financial stability. Helen has worked as a senior analyst in Holland, Hahn & Wills, a boutique wealth management firm based in England.
Helen’s research into sensible investing was the foundation for equily’s conception.
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