Barron’s Discusses Random Walks With Burton Malkiel

Two interesting articles caught my eye in Barron’s. I’ll discuss the first today and follow up with another post on the second.

This week’s issue has an interview with Burton Malkiel, the renowned author of A Random Walk Down Wall Street, and a main progenitor of the efficient market theory. Despite the recent events of the past year or so, Malkiel is sticking to his guns regarding efficient markets. A few topics intrigued me from the interview:

  • Malkiel does incorporate some behavioral finance theory in his teaching at Princeton. Despite this inclusion, he seemed a little dismissive of it, “Now, behavioral finance doesn’t give you a way to beat the market. But it teaches us a lot of lessons about how to avoid mistakes.”
  • He remains skeptical that active management can beat indexing, even as some managers continue to do so, which he doesn’t address.
  • About efficient-market theory: “In other words, there is no easy arbitrage opportunity; there is no easy way to pick up the bills. My own feeling about it is not that the $20 bills never exist. But I say pick up the $20 bill fast, because those opportunities aren’t going to be there for long.” So it’s possible to beat the market but it’s not easy and you have to act quickly? Is he defining EMT to such a refinement that it becomes meaningless?

Malkiel spends a lot of time defending his view that most markets are very efficient. I don’t know if those who disagree with EMT would dispute Malkiel’s point that markets are efficient the vast majority of time. After all, Warren Buffett’s baseball metaphor implies much the same thing. Buffett likens the markets to a baseball pitcher, throwing unlimited pitches to you, the batter/investor. Because there are no called balls or strikes, you can stand at the plate with the bat on your shoulder for as long as it takes to get a fat, juicy pitch down the middle to swing at, i.e. a great investment opportunity that promises high returns with low risk.

Seth Klarman makes much the same point. For value investors, doing nothing is a virture. Value investors do nothing most of the time because markets are efficient at pricing assets without the requisite margin of safety value investing requires. So we wait, with the proverbial bat on our shoulders.

The main difference as I see it between EMT as preached by Burton Malkiel and value investing as practiced by Buffett, Klarman, etc. is the concept of risk. Malkiel says, “…in an efficient market, you are going to get paid for taking on more risk…” Value investors reject this notion that higher risk equals higher reward. We demand high returns on low risk. Even in efficient markets like the U.S. stock market, opportunities become available, due to various of reasons such as structural bias (I would call them deficiencies) built into the financial industry.

But perhaps the main reason it is possible to beat the markets stems from basic human behavior. Malkiel asserts there is no easy way to “pick up bills”, i.e. beat the market without taking on huge risk. I don’t know of any value investor who claims it to be easy. At its core, value investing is simple but not easy. Keeping your patience and discipline is not easy. Evaluating companies with a strict eye on margin of safety while the rest of the market is losing their collective head is not easy. Watching short-term traders and momentum players book seemingly easy gains while we sit out frothy markets is not easy. Going against the herd seems easy but is anything but. Knowing the right thing to do and actually doing it are two completely different matters.

Malkiel says that behavioral finance can teach us to how to avoid mistakes but not to beat the market. However, avoiding mistakes may be the most important factor in generating high returns. If investors can avoid major and permanent capital impairment, the battle is more than half won. Buffett warns that 9 years of great returns times one year of zero still equals zero. Klarman’s legendary risk aversion borders on (prudent) paranoia. He views prevention of capital impairment as his number one task; if this task is accomplished, good returns follow almost of their own accord.

In the end, two very different ways of viewing the investment world. To be fair, the 2008 crash laid low efficient-market followers and value investors alike. Despite the carnage, the debate rages on.

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