Investors often wonder whether they should actively manage a portfolio by picking individual stocks, or if they should simply passively invest in a fund. To best answer that question, they should ask themselves, “Do I have an investing edge?”

A passive investor in an index fund, for instance, can expect to earn a return close to that of the index. An active investor has a chance to earn more than the index, but to do so they would need to do better than the average investor, many of whom are very smart and sophisticated, and often a professional. While you may certainly do very well picking individual securities, if you hope to outperform you need to have some edge, that is, a particular skill or expertise. Otherwise, you would almost certainly be better off opting for mutual funds or exchange-traded funds (ETFs). For example, an investor who chooses the Vanguard S&P 500 ETF (VOO) will earn a return net of fees almost identical to that of the broad market, as measured by the S&P 500 index.

The Challenge of Beating Efficient Markets

If you pick up an investing textbook you are sure to find a discussion of the efficient markets hypothesis (EMH), which holds that an investor cannot hope to consistently earn abnormal risk-adjusted returns—that is, beat the market—because the market is “efficient.” The theory posits that since all available information is reflected in stock prices, no investor has an advantage relative to others and so can’t hope to outperform.

The theory has three forms that build on each other. The first, the weak form, holds that examining historical prices offers no advantage. The second, the semi-strong form, argues that there is no benefit to be derived from analyzing publicly available information, such as a firm’s financial statements. The third, and most restrictive, is the strong form, which argues that even the use of insider, or material non-public, information offers no investor any advantage.

The weak form suggests that there is no benefit to technical analysis, even though it offers insights into supply and demand, which is notably missing from fundamental, or pure financial, analysis. The semi-strong form suggests that financial analysis is pointless, since prices reflect all available financial information. But, as the Grossman-Stiglitz paradox points out, if stock analysis is pointless then how can the information be incorporated into the stock’s price? The strong form holds that insider trading is not profitable. However, while illegal, the evidence demonstrates that this activity can lead to superior returns.

The efficient market theory is correct in its premise that everyone potentially has access to the same information, at least that which is publicly available. Where it fails, I suggest, is in assuming that no one can consistently utilize that information more advantageously than others can. Consider the game of chess. The rules are deceptively simple and could be written on one or two index cards. Most of us probably learned them in grade school. Therefore, we all have perfect information about it, and yet it is a near certainty that in a game of chess the Norwegian grandmaster, Magnus Carlsen, could beat anyone who reads this article. If Carlsen, indisputably a chess genius, can trounce his opponents in a relatively simple game, is it such a stretch to imagine that a gifted investor could outperform his average opponent? Many successful investors, including Peter Lynch and Warren Buffett, have demonstrated that they could.

The Wisdom of Crowds

In a 1987 article, finance professor Jack Treynor described an interesting experiment that he conducted among his students. Presenting them with a jar full of jelly beans, he asked each student how many beans it contained. Not surprisingly, some guesses were too high, while others were too low. But what might be surprising was that the average of all the guesses was closer to the actual number than all but one or two of the estimates. And this result was consistent across each class he surveyed. In other words, the crowd was collectively more accurate than most individuals. Relating this example to the stock market, we might conclude that, in general, a stock’s price is likely to be close to the “true” value.

Unlike the jelly beans, the “true” value of a stock, of course, can only be known in hindsight. We can consider the “true” value to be the present value of the firm’s expected future cash flows per share. An investor who is better than others at forecasting those future cash flows may well outperform the market.

In discussing his experiment, Treynor pointed out that the errors of the students who guessed too high tended to cancel out the errors in the guesses that were too low, so that the average was reasonably accurate. Of course, at times there can be biases, such as students collectively failing to correctly account for the air gap at the top or for the width of the jar’s wall, the consequence being that the crowd overshot or undershot the true number. It is possible that, at times, the market price of a stock may be similarly biased upward or downward if investors collectively share an unduly optimistic or pessimistic outlook for the stock.

Indeed, when investors rely on experts, the professor concluded, prices are more likely to deviate from their true values. He offered an example: Suppose an analyst publishes an estimate that has an error of 10% of the true value, and that he is five times more accurate than the average investor. If 10,000 investors abandon their independent valuations and follow his opinion, the error in the stock’s price will be 20 times as large as the error before publication of the estimate. (In general, the size of the error depends on the square root of the number of independent opinions. However, for those following the analyst, there is no canceling out of errors.) In general, therefore, the more persuasive an analyst or other stock pundit is or the more widely shared an opinion about a stock is, the less efficient the market tends to become.

The Madness of Crowds

Although crowds often exhibit a collective intelligence, such as Adam Smith’s invisible hand that drives free markets, crowds can also be driven to folly. While behavioral finance—the study of how emotions such as greed influence investors—is a relatively new area of research, it has in fact been long known that at times large numbers of investors can abandon reason for hope.

In the 1890s, for instance, the French psychologist Gustave Le Bon argued in his book, “The Crowd: A Study of the Popular Mind,” that while individuals can be rational, when they act as a group “crowds display a singularly inferior mentality … the fact that they have been transformed into a crowd puts them in possession of a sort of collective mind which makes them feel, think, and act in a manner quite different from that in which each individual of them would feel, think, and act were he in a state of isolation.”

History is replete with examples of crowds being caught up in a collective hysteria, some described by Charles Mackay in his 1841 classic, “Extraordinary Popular Delusions and the Madness of Crowds.” In addition to the South Sea Bubble and the Dutch tulip bubble that Mackay described, in more recent years we have seen the dot-com bubble and the real estate bubble, when crowds seem gripped by a myopic belief that valuations can only increase. The famed speculator Joe Kennedy described how he avoided the 1929 market crash, realizing that it was time to exit the market when shoeshine boys were asking him for stock tips. As the law of supply and demand might suggest, if every potential investor such as Kennedy’s shoeshine boy was already in the market, who else was left to propel its speculative rise?

Even when the market is otherwise rational, investors can collectively make the same errors consistently. Noted fund manager Jeremy Grantham observed how investors regularly overpay for stock of firms that have high margins, even though those margins are likely to decrease and revert to the mean, leading to poor investment returns. Similarly, investors tend to avoid firms with low margins, even though they are likely to increase and revert to the mean. These firms will outperform, leading to underperformance by the investors who avoided them. Grantham also pointed out another error many investors make when they react negatively to inflation, driving down price-earnings (P/E) multiples, even though, in the long run, inflation tends to be irrelevant for many stocks.

Opportunities for Finding Mispriced Stocks

If stocks are fairly priced, most of the time, can we indeed hope to outperform the market, or should we just buy an index fund? It depends on your investing edge. Even before the internet, Benjamin Graham, the father of value investing and co-author with David Dodd of the classic text, “Security Analysis,” recognized that the markets were becoming quite efficient. He pointed out in one of his last interviews that for most investors, doing detailed financial analysis seeking mispriced stocks was not worth the effort. His advice was to invest in a diversified portfolio of low-priced stocks.

However, even if we believe the markets are largely efficient, there may still be opportunities for the astute investor. Economist Robert Shiller pointed out in 1981 that stock prices are more volatile than could be justified by the change in the dividends they pay. As John Huber pointed out his May 2017 AAII Journal article “What Is Your Investing Edge?,” even the largest of firms get mispriced in the market. For example, Table 1 shows the high and low prices over the last 12 months for the 10 largest firms in the Russell 1000 growth index.
 

Table 1. 52-Week Price Change for a Sample of Large Growth Stocks*

The average change in price for these firms is 76.1%. Price swings of this magnitude might reasonably be expected for small firms, but for the largest firms in the market this volatility is striking. Perhaps not surprisingly, the volatility for the largest firms in the Russell 1000 value index is more muted, although still more than 50%, as shown in Table 2. [Note that Alphabet Inc. (GOOGL) and UnitedHealth Group Inc. (UNH) are in both indexes.]
 

Table 2. 52-Week Price Change for a Sample of Large Value Stocks*

Indeed, growth stocks may be the hardest to value. As investment professional Terence Dean Williams pointed out in a celebrated 1981 speech (“Trying Too Hard”), there is no such thing as a growth company, only firms going through a passing phase of growth. Because of this, it is particularly difficult to correctly value a growth stock when you are uncertain about its future growth rate. He commented, “That was what Benjamin Graham meant. It wasn’t just that he thought it was hard to estimate earnings far into the future. It is that he didn’t think it could be done accurately enough to value those stocks properly.”

Like Graham, Williams suggested opting for a diversified portfolio of value stocks. He gave an example of an investor choosing between two portfolios, one with companies considered to have bright prospects, and priced to reflect those expectations. Almost certainly some of these firms will perform worse than expected, leading to disappointing investment returns. The other portfolio holds companies that are not expected to perform particularly well, and so will be comparatively cheap. Again, some of these will surprise, in these cases performing better than expected. Given low expectations, the investor didn’t pay up for performance, and so this second portfolio is the one that is likely to outperform.

Superinvestors

While Graham’s student Buffett encourages most investors to simply opt for a low-cost index fund, he wrote in a 1984 article, “The Superinvestors of Graham and Doddsville,” that there is always likely to be, from time to time, a disconnect between the price of a stock and what it is worth. He suggested that, because of greed or depression, or other emotions, “it is hard to argue that the market always prices rationally. In fact, market prices are frequently nonsensical.” In Buffett’s opinion, a disciplined investor can profit from these mispricings. Not everyone has the temperament and patience to take advantage of these opportunities, however. Buffett’s business partner Charlie Munger observed that “It takes character to sit there with all that cash and do nothing. I didn’t get to where I am by going after mediocre opportunities.”

Contrarian Investing or Mistiming Investments

Dalbar Inc., a firm that studies investor performance, consistently finds that the average mutual fund investor underperforms the market. From 2001 through 2020, for instance, while the S&P 500 returned around 7.5%, Dalbar reported that the average investor in equity mutual funds earned less than 6%. Investors tend to buy too high and, often because they panic, they tend to redeem their funds or switch from equity funds to a money market or bond fund in response to a market decline.

This type of behavior has been observed for over 100 years. In the 1917 book, “One-Way Pockets,” for instance, a stockbroker using the nom de plume Don Guyon described an analysis that he performed in 1915 of the accounts of his six most active clients. Looking at the most actively traded issues, he found that, despite the large gains in the prices of the stocks in the period in question, “the average price at which each stock was bought for the six accounts was higher than the average price at which it was sold.” This insight into the irrational behavior of his clients led him to the conclusion that “the only speculative method that would prove profitable in the long run must be the reverse of that followed by the consistently unsuccessful public.”

To profit from mispricings, it is not enough to simply buy those stocks that are underpriced. Their prices must subsequently rise in order for you to profit. The British economist John Maynard Keynes, who observed that “markets can stay irrational longer than you can stay solvent,” argued that a successful investor needs to be a complex thinker. He compared investing to a beauty contest, but one with a twist, in which competitors have to choose the six prettiest faces from 100 photographs, with the winner being the competitor whose choice was closest to the average choices of all the competitors. A first-level thinker would simply pick the faces they considered the prettiest; a second-level thinker would pick the faces they expected that the majority of competitors would choose; but a third-level thinker, assuming the other competitors to be second-level thinkers, would pick the faces they believe average opinion expects the average opinion to be. Returning to our underpriced stocks, unless the market in general recognizes that they are undervalued, their prices are likely to continue to languish, so you should choose those mispriced stocks that you believe others will eventually recognize as undervalued.

Conclusion

The markets are broadly efficient, although we should recognize that this is a consequence of the independent actions of market participants rather than a preordained rule, so that when these actions are irrational, prices too will be irrational. Despite this broad efficiency, if you have an investing edge, and can evaluate stocks better than others, it may be possible to outperform the market. That edge may be, as Buffett calls it, a “circle of competence,” such as an insider’s technical knowledge of biotechnology or information systems. On the other hand, it may simply be a behavioral edge, an ability to remain detached from the emotional excess of the market in general and wait—sometimes for a year or two—for Graham’s Mr. Market to offer you stock in excellent firms at very appealing prices.

As Williams pointed out, having a consistent investment strategy is very important. With discipline and patience, as Buffett and Munger demonstrate, it may be possible for an investor who arrives at an independent opinion and avoids the market’s potential groupthink to match or exceed the returns of the market by picking individual stocks or, indeed, funds. However, I suggest that it is not possible for the average investor to do so. To earn better-than-average returns, you need to be a better-than-average investor, and to behave accordingly.

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