Is the Stock Market Really Efficient?

Chapter 11 is where Malkiel fights back. After spending the last chapter letting behavioral finance people take their best shots at the efficient market theory, he rolls up his sleeves and defends it. Researchers have been trying to kill this theory for decades. Malkiel says they keep missing.

First, what does “efficient” actually mean?

Here’s what trips people up. “Efficient” doesn’t mean the market is always right. It can’t be. Nobody can perfectly predict future cash flows. So prices are always a little wrong.

What “efficient” really means, according to Malkiel, is two things. One, the market absorbs new information quickly. Not instantly, not perfectly, but fast. Two, there are no free lunches sitting around. You can’t earn above-average returns without taking above-average risk.

He tells this joke about a professor who believes in efficient markets. The professor and a student spot a $100 bill on the ground. The student reaches for it, and the professor says, “Don’t bother. If it were really a $100 bill, it wouldn’t be there.” That’s the idea. Maybe there’s some loose change lying around. But hundred-dollar bills? Gone before you can pick them up.

The potshots that completely miss

People have found all sorts of “predictable” patterns in stock prices. Malkiel goes through them one by one.

Dogs of the Dow. Buy the ten highest-yielding stocks in the Dow Jones average each year. These are the most out-of-favor stocks, so they should bounce back. And historically, they did. For a while. Then over $20 billion poured into Dogs of the Dow funds. The strategy became too popular and stopped working. The creator himself admitted it self-destructed.

The January Effect. Stocks, especially small ones, tend to produce unusually high returns in the first two weeks of January. The explanation? People sell stocks in December for tax losses, depressing prices. Then prices bounce back in January. Sounds great. But the trading costs for small stocks eat up the gains. And the effect doesn’t show up every year. So the “loose change” costs too much to pick up.

The Monday Afternoon Pattern. Stock returns from Friday close to Monday close tend to be negative. So you should buy on Monday afternoon? Sure, except the effect is tiny compared to what it costs to trade on it.

Hot News Response. Some researchers say stocks underreact to good or bad news, so you could profit by trading on earnings surprises. But Eugene Fama showed that overreaction happens just as often. The anomalies mostly disappear when you use different models. He concluded they can “reasonably be attributed to chance.”

The pattern here is clear. Any truly exploitable pattern self-destructs once people find it. If everyone knows to buy in late December and sell in early January, they start buying earlier and selling earlier until the pattern evaporates. As one person put it, “The January Effect sometimes occurs on the previous Thanksgiving week.”

The potshots that get closer

Some attacks on market efficiency are more serious. These actually have real data behind them.

Short-term momentum. Stock prices do show some persistence in the short run. A good week is more likely to be followed by another good week. Lo and MacKinlay found this pattern across decades. But here’s the thing. The effect is statistically real but economically useless. Transaction costs wipe out any profits. Terrance Odean studied actual momentum traders and found they did far worse than buy-and-hold investors, even during periods with clear positive momentum.

The dividend yield predictor. When the overall market’s dividend yield is high, future returns tend to be generous. When yields are low, future returns tend to be poor. Fama and French found that initial dividend yields could explain up to 40 percent of the variability in ten-year returns. But Malkiel points out that high dividend yields usually coincide with high interest rates. The pattern might just reflect normal economic cycles, not some exploitable inefficiency. And corporate behavior around dividends has changed. Companies now prefer stock buybacks to cash dividends, making dividend yield less meaningful than it used to be.

The P/E predictor. Similar story. Buy stocks when market P/E ratios are low, and your returns tend to be better. Campbell and Shiller showed this explains over 40 percent of ten-year return variability. But a colleague of Malkiel’s switched his entire retirement into bonds in the early 1990s because P/Es looked high. He was very sorry for the next ten years. Low P/Es often mean high interest rates. The pattern is real but unreliable as a timing tool.

Long-run mean reversion. Stocks that did poorly over three years tend to do better over the next three. Sounds like a contrarian dream. But Malkiel and his colleagues simulated this strategy and found that the “losers” only recovered to average market returns. Not above average. Just back to normal. And sometimes the beaten-down stocks are beaten down for good reason. Ask anyone who bought Enron or AIG on the way down.

The small-cap premium. Small company stocks have returned about 1.5 percentage points more per year than large company stocks since 1926. But small companies are riskier. Their stocks cost more to trade. And the effect comes and goes. It worked in the early 2000s. It didn’t work much in the 1990s. There’s also survivorship bias. The studies only include small companies that survived. All the ones that went bankrupt aren’t in the data.

Value beats growth. Benjamin Graham and David Dodd argued back in 1934 that stocks with low P/E ratios and low price-to-book ratios outperform. Fama and French confirmed it with rigorous data. But when you look at actual mutual fund returns going back to the 1930s, value funds and growth funds performed about the same over the full period. The value advantage may have been limited to specific decades.

Why even the close shots still miss

The most powerful argument comes from looking at what professionals actually achieve. If all these patterns are real and exploitable, professional fund managers should be crushing the market. They’re not.

Over five years ending January 2010, roughly 60 to 90 percent of actively managed funds underperformed their benchmark indexes. Every category. Large-cap, mid-cap, small-cap, international, emerging markets. The index won across the board.

Then there’s survivorship bias in mutual funds. Bad funds don’t stick around. Fund companies merge their losers into winners, burying the evidence. Some companies start ten “incubator” funds, wait to see which three beat the market, and only market those three. The others vanish. So the published track records of surviving funds look better than what investors actually experienced by about two percentage points per year.

One exchange in the chapter says it all. Robert Shiller stressed the importance of market inefficiencies. Richard Roll, an academic who also managed billions in real money, responded: “I have personally tried to invest money in every single anomaly and predictive device that academics have dreamed up. And I have yet to make a nickel on any of these supposed market inefficiencies.”

Another portfolio manager back-tested his quantitative strategy over twenty years. It beat the S&P 500 by three points a year. Then he tried it with real money. Over the next twenty years, he barely matched the index after expenses. His confession? “I have never met a back test I didn’t like.”

The bottom line

Malkiel isn’t saying markets are perfect. He freely admits that bubbles happen, that psychology influences prices, and that short-term patterns exist in the data. The tulip mania was real. The Internet bubble was real. The 2008 crash was real.

But here’s his core point. Knowing that bubbles exist after they pop is not the same as profiting from them while they inflate. Nobody consistently calls the top. The models that “predicted” the Internet crash also called the market overpriced in 1992, right before one of the best decades in stock market history. Greenspan’s “irrational exuberance” speech in 1996 came before several more years of massive gains.

Markets may not be perfectly efficient. But they’re efficient enough that you can’t systematically beat them after accounting for costs, taxes, and risk. The $100 bills are never lying around for long.

The practical takeaway is the same one Malkiel has been making since 1973. Buy a broad index fund. Hold it. Stop trying to outsmart everyone else. Most of the professionals can’t even do it. And they do this for a living.

Previous: Your Brain Is Bad at Investing: Behavioral Finance Next: Getting Your Financial House in Order Part of the series: A Random Walk Down Wall Street Book by Burton G. Malkiel | ISBN: 978-0-393-08169-5