Harry Markowitz
Harry Markowitz

In this volume, Mark Hebner meticulously refutes the idea that investors can beat the market by stock selection or market timing. Some readers may react with the thought that “perhaps most investors cannot beat the market, but some can. I merely have to emulate those with superior performance.” Examples of investors with sustained superior performance include the legendary Warren Buffett and David Swensen, Yale University’s chief investment officer, whose performance over decades has been widely admired and imitated by endowment and retirement plan managers, but with rare success.

If you examine the words and practices of these distinguished investors, you will find their above-market performance is not due to a set of rules which can be followed by individual investors. Rather, it is due to resources and opportunities which individual investors and most institutional investors do not have.  Swensen tells how he does it in his book, “Pioneering Portfolio Management: An Unconventional Approach to Institutional Investment.” As noted in the title, Swensen’s book explains how an institutional investor (as distinguished from an individual investor) might achieve above-market returns. He observes there is little chance for beating the market with well-followed securities such as large-cap and small-cap stocks. As to opportunities available to the institutional investor from less conventional sources, Swensen writes: “Populated by unusually gifted, extremely driven individuals, the institutional funds management industry provides a nearly limitless supply of products, a few of which actually serve fiduciary aims. Identifying the handful of gems in the tons of quarry rock provides intellectually stimulating employment for the managers of endowment portfolios.” 1

Few, if any, individual investors have the time and skill to separate the “gems” from the “quarry rock,” even if they were presented with similar opportunities. Any individual investor who believes he or she can achieve above-market performance is almost sure to underperform the market substantially.

Hardly any institutional investors are able to outperform their proper benchmarks. Among those who do accomplish this feat, their ranks largely change from year to year, making their discovery a moving target, as Mark Hebner shows in this volume. Swensen affirms the difficulty of identifying skilled fund managers. He states, “I erred in describing my target audiences. In fact, I have come to believe that the most important distinction does not separate individuals and institutions… few institutions and even fewer individuals exhibit the ability and commit the resources to produce risk-adjusted excess returns.2

Indeed, the challenge of ferreting out the gems from among the “tons of quarry rock” is more challenging than it might first appear.

While Warren Buffett has not written a text on the subject, his actions show his success — like Swensen’s — is in part due to his being offered opportunities not available to the individual investor. Specifically, he is offered the opportunity to take large positions in established companies at favorable prices. At such times, company information is made available to Mr. Buffett and his staff which is not routinely available to the public. Ultimately, however, it is his and his staff’s ability to evaluate such positions — to separate the gems from the quarry rock — that explains their long-run success. As in the case of Swensen’s outperformance, few individual investors have the time and skill to evaluate such opportunities, even if they were presented to them.

As to market timing, I know of no one who has consistently outperformed the market by market timing. Since there are always countless “authorities” who say to buy, and countless others who say to sell, there will always be many instances in which someone called correctly the last turn of the market, and even the last two or three turns. As Mr. Hebner documents, it is a foolish hope to try to emulate such market timers. It is better to go with J.P. Morgan’s advice — that all one knows about the market is that it will fluctuate.

J.P. Morgan’s observation has at least three implications. The obvious one is: Don’t try to time the market. You will make your broker rich, not yourself. Another implication is you should choose a portfolio you can live with despite market fluctuations. For example, the year 2008 was not an “outlier,” nor was it even the worst year on record. Rather, it was tied for the second-worst year. It was a one-in-forty year event, not a one-in-a-thousand year event. The frightened investor who decided to get out of the market in March 2009 locked in his or her losses for good. The chief problem with investors is they buy after the market has gone up and believe it will rise further, and they sell after the market has fallen and believe it will fall more. One of the principal functions of the right financial advisor is to make sure the investor understands the volatility of his or her specific portfolio and is willing to stick with it for the long-run.

As Mr. Hebner explains, a third implication of the fact that markets fluctuate is the need to rebalance. Suppose an investor is comfortable with a 60-40 mix of stocks versus bonds. If the market has risen substantially, the portfolio’s equity exposure will greatly exceed sixty percent. The rebalancing process sells off the excess, bringing the portfolio back to a 60-40 mix. If the market has fallen, then the portfolio will have less invested in stocks than the target 60 percent. The rebalancing process then buys. This process of rebalancing — which sells after the market has gone up and buys after the market has gone down — is sometimes referred to as “volatility capture” and leads to what Fernholz and Shay (1979) refer to as “excess growth.”3 The rebalanced portfolio will grow faster than the average growth of its individual constituents. It may even grow faster than any one of its constituents due to the rebalancing process. Thus, if handled knowledgeably, market volatility can be the investor’s friend.

“Money in the bank” sounds safe, but will do little to outpace inflation. On the average, over the long run, a well-diversified portfolio that includes stocks and bonds will almost surely continue to outpace both inflation and money in the bank. However, as this book documents so well, a foolish attempt to beat the market and get rich quickly will make one’s broker rich and oneself much less so.

– Harry Markowitz, Ph.D.
1990 Nobel Prize Recipient

Harry Markowitz, Ph.D. is best known for his pioneering work in Modern Portfolio Theory, for which he was awarded the 1990 Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel (referred to as the Nobel Prize in this book). In 1952, he developed the simple, yet profound notion that investors must consider the risk associated with their investments, not solely the return. This groundbreaking discovery sparked a financial revolution pertaining to the relationship between risk and return. He is widely known as the “Father of Modern Portfolio Theory”. Dr. Markowitz is also the recipient of the 1989 John von Neumann Prize in Operations Research Theory for his work in the areas of sparse matrix techniques and the SIMSCRIPT programming language, in addition to portfolio theory. He currently serves as an Adjunct Professor of Finance at the Rady School of Management at the University of California, San Diego.

    -1 David Swensen, Pioneering Portfolio Management: An Unconventional Approach to Institutional Investment (New York: The Free Press, 2000).
    -2 Ibid., pg. 3.
    -3 Robert Fernholz and Brian Shay, "Toward a Dynamic Theory of Portfolio Behavior and Stock Market Equilibrium," Department of Statistics, Princeton University, Technical Report No. 163. Series 2 (1979).
Harry Markowitz