Note to Readers: We are pleased to publish a guest article by Meir Statman, the author of What Investors Really Want. Professor Statman is a pioneer in the field of behavioral finance and his book should be required reading for anyone involved in financial markets. Whether an investor is “seeking alpha” or satisfied with the low cost approach of index funds, investing without a keen appreciation for the behavioral pitfalls that impact nearly all of us can be a costly mistake.
Value Investing in Inefficient Markets
By Meir Statman
November 30, 2010
Value investors often describe themselves as following the teachings of Warren Buffett who refined the lessons of Ben Graham. They look at the crazy behavior of the market, observe that it is inefficient, and conclude that they can easily beat it. But this is not what Buffett teaches. The market might be inefficient, even crazy, but a crazy market does not turn us into psychiatrists. Investors can do themselves great harm if they believe that they can read Barron’s for a couple of hours on Saturday and then invest like Warren Buffett on Monday.
The puzzle of the beat-the-market game is the market efficiency puzzle. There are two main definitions of efficient markets, one ambitious and the other modest. The ambitious definition is better called rational markets. Rational markets are markets where investments with returns higher than risks do not exist. More modest is the definition of “efficient markets” as unbeatable markets. Unbeatable markets are markets where investments with returns higher than risks exist, but most investors are unable find them.
Warren Buffett illustrated the distinction between rational markets and unbeatable markets and the confusion that arises when they are lumped together. Buffett was considering buying bonds of Citizens Insurance, established by the state of Florida to cover hurricane damage and backed by state taxes. Berkshire Hathaway, his company, received offers from three sellers of these bonds at three different prices, one at a price that would yield Berkshire Hathaway a 11.33 percent return, one at 9.87 percent and one at 6.0 percent. “It’s the same bond, the same time, the same dealer. And a big issue,” said Buffett. “This is not some little anomaly, as they like to say in academic circles every time they find something that disagrees with their [efficient market] theory.”
Buffett used the term “‘efficient market”’ where the term “‘rational market”’ would have been more precise. The story of the Citizens Insurance bonds is, as Buffett noted, an anomaly, contradicting the claim that the market for these bonds is rational. If investors in the 6.0 percent bond are receiving returns equal to risks then investors in the 9.87 percent and 11.33 percent bonds receive returns higher than risks. Yet Buffett cautioned investors not to jump too fast from evidence that markets are not rational to a conclusion that they are easily beatable. When asked for advice Buffett said: “Well, if they’re not going to be an active [beat-the-market] investor—and very few should try that—then they should just stay with index funds. Any low-cost index fund. . . . They’re not going to be able to pick the right price and the right time.”
We know from Buffett’s bond story and much other evidence that markets are not rational; investments with returns higher than risks do exist. Moreover, we know that markets are not unbeatable for insiders and skillful investors such as Buffett. But we should not jump from the conclusion that markets are beatable by some to the conclusion that they are beatable by all.
Indeed, markets are beatable by some because they are not beatable by all. The extra returns of Buffett and his brethren over the returns of index fund investors come from diminished returns of beat-the-market investors who find themselves on the other side of the net from Buffett and his brethren.
Buffett followed his words with deeds. On January 1, 2008, Buffett placed roughly $320,000 on a bet that the S&P 500 Index would outperform a portfolio of hedge funds over the following ten-year period. On the other side is Protege Partners, LLC, a hedge fund company, whose people placed an identical amount on a bet that the hedge funds they have chosen would beat the S&P 500 Index. All the money is now in a zero-coupon bond that would grow to $1 million by December 31, 2017, and go to charity, to Absolute Returns for Kids if Protege wins, and to Girls Inc. if Buffett does.
Protege argued that “Funds of [hedge] funds with the ability to sort the wheat from the chaff will earn returns that amply compensate for the extra layer of fees their clients pay,” and noted that Paulson & Co. hedge fund is among its investments. John Paulson made billions in profits by selling short investments linked to subprime mortgages. But Buffett said, “A lot of very smart people set out to do better than average in investment markets. Call them active [beat-the-market] investors. Their opposites, passive [index] investors, will by definition do about average.” But investors in hedge funds are unlikely to overcome their costs. “Investors, on average and over time,” concluded Buffett, “will do better with a low-cost index fund than with a group of fund of [hedge] funds.”
Are you sure that you are one of the very few of should try to beat the market? Are you sure that your returns would not be higher if you invested in a widely diversified value index fund? Are you sure that Buffett is not the seller of the shares you buy? I’m not sure that I’m one of the few, so I invest in index funds. I think that Buffett approves.
Meir Statman is the Glenn Klimek Professor of Finance at the Leavey School of Business, Santa Clara University, and Visiting Professor at Tilburg University in the Netherlands and the author of What Investors Really Want (McGraw-Hill). His research on behavioral finance has been supported by the National Science Foundation, CFA Institute, and Investment Management Consultants Association (IMCA) and has been published in the Journal of Finance, Financial Analysts Journal, Journal of Portfolio Management, and many other publications.
A recipient of two IMCA Journal Awards, the Moskowitz Prize for Best Paper on Socially Responsible Investing, and three Graham and Dodd Awards, Statman consults with many investment companies and presents his work to academics and professionals in the U.S. and abroad. Visit his blog: http://whatinvestorswant.wordpress.com/