There's a bear in there

Despite talk in recent years about Australia being better shielded from global fluctuations, it still seems that when America sneezes, Australia catches a cold. And with our stock market losing nearly an eighth of its value over the fortnight prior to January 23, 2008, some investors are naturally wondering whether shares are really such a good place to keep their assets (as distinct from, say, a shoebox under the bed).

In such an environment, it’s worth recalling a few lessons that economics research has taught us about the stock market. While some have become common wisdom among investors, others are yet to percolate from the campus to the trading floor.

The first is that the long-run record of stocks is very good. While shares are typically more volatile than property and bonds, their long-run performance has been better. Particularly for investors with a reasonable time horizon, nothing beats shares. This is why investment advisers typically suggest that a person in their 20s or 30s should have more than half of their investments in shares (a rule of thumb that is sometimes difficult to follow if you want to also buy a house in a big Australian city).

The second lesson is that most traders trade too frequently for their own good. In a paper in the American Economic Review last year, Ilia Dichev (University of Michigan) showed that in most share markets around the world, the typical “buy and hold” return is higher than the “dollar-weighted” return. From 1973-2004, the typical stock on the Australian market earned a return of 12.3 per cent per year. But the typical investment dollar earned an annual return of 11.7 per cent. The problem is that investors tend to buy and sell at the wrong times - over investing in stocks before they peak.

The moral here for investors is that a passive investment strategy tends to lead to better long-term returns than jumping from fad to fad. Such a strategy avoids the mistakes identified by Dichev, and minimises brokerage fees. (Incidentally, the same often holds true in at the supermarket, where switching from one checkout line to the next is rarely optimal.)

The third lesson from economics is that in an efficient market, stock prices incorporate all publicly available information about the firm. Consequently, short-run changes in stock prices cannot be predicted. As Burton Malkiel put it in his 1973 classic, A Random Walk Down Wall Street, this means that a portfolio chosen by “a blindfolded monkey throwing darts at a newspaper’s financial pages would do just as well as one carefully selected by the experts”.

A clear implication of Malkiel’s study is that investors cannot make money from obvious information. For example, the recent rise in Australia’s birth rate is likely to increase consumer demand for baby toys. But any consequent increase in profitability in toy-making companies has already been factored into their share prices.

A less obvious implication is that index funds tend to outperform managed funds. Tracking 355 US equity mutual funds over the period 1970-2001, Malkiel showed that only 22 managed to achieve a higher return for their investors than the S&P 500 index. Of the remaining 333 funds, 50 achieved about the same returns as the market as a whole, 86 underperformed the index, and 197 did not survive.

But surely the 22 high-performing funds have something to brag about? Not so fast. To test whether their success was due to luck or skill, Malkiel took the best-performing funds of the 1970s, and looked to see how they did in the 1980s. In virtually all cases, out performance in one decade was followed by under performance the following decade. The same was true the next decade. The top mutual funds in the 1980s tended to be low-performers in the 1990s. Rarely do active money managers make enough to justify their fat fees. Most investors would do better in an index fund.

Of course, all this ignores the fact that many day traders are in the markets not only to make a buck, but also for the excitement of buying and selling. After all, where’s the adrenalin rush from following sensible economic principles and putting your money in an index fund? While few traders consistently beat the market, most still manage to turn a profit. If it’s a choice between the share market and the casino, go for shares - and may Lady Luck smile upon you.