The Guide to Investing in Stocks and Shares

Random Walking

Dan Tebbutt - A Shareworld Contributor

I've recently been re-reading A Random Walk Down Wall Street by B.G.Malkiel.  It's an investment classic that makes a strong case in favour of the Efficient Market Theory - the idea that the financial markets price risk and reward so effectively that a participant in the market cannot consistently earn above-average returns without taking above-average risk.

He quotes a well-known anecdote to illustrate the theory: "A finance professor and a student come across a $100 bill lying on the ground.  As the student stops to pick it up, the finance professor says 'Don't bother - if it were really a $100 bill, it wouldn't be there.'"

The book is an entertaining read, and I have to agree with Malkiel in thinking that most of the time, most of the market is quite efficient.  After all, there are millions of smart people trying to beat it at any given moment - any obvious mispricings should quickly be corrected by the law of supply and demand as eager investors snap up a bargain.

However, I disagree with Malkiel on a few points: 

• I think that occasionally the market as a whole can be so thoroughly irrational that a clear-headed individual, ploughing their own intellectual furrow, can go against the prevailing opinion and beat the market.  I think the dot-com boom was one such example, and to a lesser extent the buying opportunities afforded by the recent financial panic.

• I think that in the context of a mostly rational market there can be occasional sectors or shares which are obviously mispriced.  The price of bank preference shares in May, in comparison to the ordinaries is the clearest recent example that I know of.  There had been a strong recovery in the price of ordinary bank shares in the months beforehand, but this hadn't been mirrored in the preference shares.  In May it seemed clear that holding preference shares was a far better choice, and I'm glad to say I backed my thoughts with deeds, selling RBS at 50p and buying LLPF at £285.  At the time of writing RBS is down 40% from that point, and LLPF was exchanged at £700 per share.

• I think that to some extent the market reverts to the mean.  In one period shares might outperform, and in the next bonds, or real estate.  A strategy of keeping a diversified portfolio, and regularly rebalancing it, should give a better return than simply buying and holding any individual asset class.

But what if I'm wrong, and the market really is perfectly efficient?  In that case, as far as I can see, the only downside to the path I'm pursuing is the potential frictional cost of trading too often, rather than just buying and holding forever.

After all, if the market is efficient, then it doesn't matter what shares I buy - a reasonably diverse portfolio is simply likely to give me the same return as the market (or, if I'm taking on above average risk, it should give me an above average return).  In fact, by avoiding actively managed funds I will have avoided the management fees that mean so many funds underperform - even a tracker usually charges over 0.5% per year in fees.

I am aware of the pitfalls of trading too often, and I am intentionally trying to keep my trading costs down.  I have held onto most of my shares since purchase.  I also track my costs explicitly along with my portfolio performance.  So far my annual costs in stamp duty and brokerage amount to 0.4%.  That compares pretty favourably to the cost of a tracker, and beats most managed funds hands down.