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FORTUNE magazine says: since no one can beat the market long term the only option is to buy and hold...did they post this article in the Japanese edition too? ..gggggg

Is the Market Rational?
No, say the experts. But neither are you--so don't go thinking you can outsmart it.
FORTUNE
Tuesday, December 3, 2002
By Justin Fox


Meanwhile a few finance scholars of a more diplomatic bent than Cootner began spreading their ideas of risk and return in the real world. Princeton economist Burton Malkiel's A Random Walk Down Wall Street, published in 1973, probably played the biggest role in bringing efficient-markets thinking to the retail investing masses. But on Wall Street itself, the most important messenger was William Sharpe.

Sharpe, now 68, grew up in Southern California and learned his economics at UCLA. He was of the efficient-markets school, but his work (for which he won the economics Nobel in 1990) appealed even to those who still hoped to beat the market. In an efficient market the only way to outperform the market is to take on more risk. Sharpe devised a simple measure of risk based on past volatility, called "beta," that could be used to build balanced portfolios--and to measure whether active money managers were actually beating the market or just taking on extra risk.

Sharpe wasn't content to make his point merely in academic journals. He wrote textbooks on investments and finance and did so much consulting for Wall Street firms and pension funds that he gave up full-time teaching at Stanford in the mid-1980s. In 1996 he even launched a dot-com, Financial Engines, to make his advice available to small investors. So while Sharpe believes in efficient markets, he has also spent much of his career helping investors make choices. That, it turns out, makes him a big fan of behavioral finance. "As a practical matter, I still think it's prudent to assume that the market is pretty close to efficient in terms of pricing and risk and return and all that," Sharpe says. "On the other hand, we've certainly learned from cognitive psychology that ordinary human beings need to have alternatives framed in ways that can help them make right decisions rather than wrong decisions."

Most of the wrong decisions investors make, behavioral research has shown, stem from overconfidence. That is, we think we know more than we do. We trade too much, we don't diversify enough, and we extrapolate from the recent past to make assumptions about what will happen next.

As a result, much of what the behavioralists have to offer in terms of advice has to do with protecting retail investors from themselves. That's why Thaler spends a lot of his time thinking about how best to design 401(k) plans. It's why Sharpe incorporates behavioralist research into the advice Financial Engines doles out. And it's almost certainly why Daniel Kahneman, when asked by a CNBC anchorman the day after his Nobel was announced in October what investment tips he had for viewers, responded, "Buy and hold."

When I recount Kahneman's words a few weeks later to Fama, he reacts with glee. "That means I won!" he shouts. It is, on one level, an absurd claim. The behavioralists are now clearly the dominant stream in academic finance, having made the leap from outsider status during the 1990s as a new generation of professors rose to positions of prominence. But the real-world phenomenon that cemented the behavioralists' victory also illustrates why, when it comes to actual investing advice, they sound so much like Fama and Sharpe.

That real-world phenomenon was the stock market bubble of the late 1990s. According to strict efficient-markets thinking, there must be a rational explanation for what happened. Fama describes those sky-high Internet stock valuations as a risky but not crazy bet that one or two of those money-losing Net companies would end up as big as Microsoft. But he's almost all alone on this one. "We have just lived through the biggest bubble of all time," says Malkiel, who now calls himself a "random walker with a crutch." Fama's favorite collaborator, Dartmouth's French, is on the verge of using the b-word as well when he stops himself. "I work very closely with Gene," he says. "He would be very upset if I used that word in print."

Yale economist Robert Shiller has no such compunctions about ticking off Gene Fama. In 1984 he declared that the logical leap from observing that stock price movements were unpredictable to concluding that the prices are in fact right "represents one of the most remarkable errors in the history of economic thought." That was Shiller's first brush with fame. He got more popular attention after the 1987 stock market crash, which the efficient-markets professors had trouble explaining. ("It's weird," Sharpe told a reporter at the time. Later his mother called to berate him: "Fifteen years of education, three advanced degrees, and all you can say is, 'It's weird'?")

Shiller is 56 and did his economics training under Samuelson at MIT. He and Thaler have long been allies, but Shiller seems less interested than many of the other behavioralists in assembling the cognitive-psychology building blocks of a market bubble (which would involve that persistent flaw of extrapolating from the recent past to make assumptions about what will happen next). Instead he's perfectly willing to accept at face value the conventional wisdom that markets are sometimes taken over by fads and mass hysterias. By the mid-1990s Shiller had become convinced that we were entering into one of those mass hysterias. His evidence was straightforward: Price/earn-ings ratios were really high. He began sounding the alarm wherever he could, including the offices of the Federal Reserve Board. Then he wrote Irrational Exuberance, which hit bookstores in March 2000, just as the market peaked.

The book's perfect timing was dumb luck, Shiller himself says. And while he took most of his own money out of the stock market in the 1990s, his advice to investors now is to "diversify completely" and not try to beat the market. This happens to be what Sharpe would tell you. Or Fama. Or Thaler. The dirty little secret of the behavioralists is that, for all their work on investor irrationality and market anomalies, they still believe that markets work pretty well and that trying to outguess the collective wisdom of millions of investors is usually futile. In answer to Fama's question of how they plan to calculate the cost of capital in a world where prices are incorrect, the behavioralists say that for the purposes of such calculations, they'll just assume that prices are right.

But efficient-markets theory has a dirty little secret, too, which is that for the market to remain efficient, there have to be lots of rational investors who believe enough in the market's inefficiency to spend their careers trying to beat it. Behavioralist theory, of course, has no problem accommodating the belief that some investors can beat the market. In fact, several behavioralist professors, Thaler included, have money-management firms that try to take advantage of the anomalies they discover in their research.

But there's a limit to the riches that can be dredged from market anomalies. That's because "markets can remain irrational longer than you can remain solvent."

This aphorism is usually attributed to economist and speculator John Maynard Keynes, and there are those who contend that the whole of the behavioralist case is contained in chapter 12 of Keynes's 1936 General Theory, with its wonderful depiction of investing as a game of musical chairs. But the argument of modern behavioralists includes a crucial observation that wasn't in Keynes--that professional investors are now under so much pressure from their customers that they cannot make the kind of long-term bets that might beat the market. If they do, as was the case with a lot of value-oriented mutual funds in the late 1990s, they can soon find themselves without any customers' money to invest.

That gets us to a world in which an investor with enough staying power and contrarian gumption can beat the market, but the vast majority of mutual funds and hedge funds don't. In other words, the behavioralists have reconciled the success of a Warren Buffett (which efficient-markets purists have absurdly termed dumb luck) with the overwhelmingly empirical evidence that most professional money managers fail to beat the market.

This is, we posit, a major intellectual accomplishment. What does it mean for you? That's easy: Buy and hold. Diversify. Put your money in index funds. Pay attention to the one thing you can control--costs--and keep them as low as possible.