Simple lesson in Nobel Prize-winning research: Pick index funds

Nobel Prize-winning economists Eugene Fama and Lars Peter Hansen show beating the market is tough even for the most savvy investors, and individuals can profit from a simpler approach

Eugene Fama

Eugene Fama is the recipient of the 2013 Nobel Prize in Economics. Fama is the Robert R. McCormick Distinguished Service Professor of Finance at University of Chicago. (AFP-Getty Images / October 14, 2013)

 

Pick up studies by two of this year's Nobel Prize-winning economists, Eugene Fama and Lars Peter Hansen, and the work by the University of Chicago professors might make your head spin.

But the simple conclusion from all the research is important to anyone with a 401(k) or individual retirement account. Despite the billions of dollars people spend trying to get an edge in the market by choosing specific stocks or bonds, there is little edge to capture. If you have been paying a pretty penny to professional investment experts — hoping they can outsmart all the others and make you a fortune — you probably aren't getting your money's worth.

If you merely stick to the cheapest, simplest investing approach, you have a good chance of beating most of the top-paid pros. This approach involves relying on index funds, the easy-to-buy-and-manage mutual funds or exchange-traded funds that mimic the stock market, without any brainy fund manager trying to pick winning stocks and avoid losers.

Why does that approach tend to win over time?

Because, as Fama has found, it's difficult for any expert to know much about the stock market, bonds or stocks that isn't already known by loads of other investors who spend their days looking for the best investments they can find. And if an expert doesn't find something special that others haven't discovered, he or she isn't likely to give you gains beyond what the simplest approach offers.

The Nobel Memorial Prize in economics, awarded Monday, was given to Fama and Hansen along with Robert Shiller of Yale University. Hansen was recognized for developing a statistical method of explaining asset prices, while Shiller won in part for questioning valuations. He wrote a book titled "Irrational Exuberance."

Fama has been doing research for years suggesting that low-cost, simple index fund investing tends to do more for people's wealth over time than the more elaborate approaches that cost people more.

It comes down to what Fama and other economists call "efficient market theory." With all the experts studying stocks, day in and day out, the price of a stock or the level of a stock market tends to be right for a point in time. In other words, if millions of people are reading the same news as you, what makes you think you or some pro has spotted something that will make you a unique moneymaker? If everyone loves iPhones, why do you know more about the right price for Apple stock?

According to Fama's research, stock prices on any single day incorporate all the knowledge that's in the marketplace. So the price "you see is probably close to the right answer," said professor Tobias Moskowitz of the University of Chicago Booth School of Business. You might as well choose to invest in an index fund that includes Apple and an array of other stocks and charges you little to partake.

Moskowitz compares the price of a stock to contests related to guessing how many jelly beans are in a big jar. There will be a vast array of guesses, but if you average all those guesses, "the average is close to the exact number." Likewise, he says, the price of Apple stock is "probably close to the right answer."

"That doesn't mean you can't outguess the market," he said. "But it's very hard, and if you think you are smarter than the market, you must ask yourself what you know that others don't."

This is where Shiller comes in: Anyone who can spot trouble coming — such as an asset bubble — is going to do well when most do poorly.

If you think a fund manager is smarter than the market, you must ask if his or her knowledge is enough to cover the higher fees people pay for such expertise. Investors can find index funds that charge a 0.18 percent fee, while actively managed funds, with professionals at the helm, tend to charge closer to 1 percent. That's a high hurdle to jump.

The difficulty in outsmarting the market becomes clear during almost any period when you study how different funds have performed. For example, Standard & Poor's recently completed its midyear study of mutual funds and compared index funds and those run by a professional trying to pick winning stocks and avoid losers.

But when S&P analyzed how funds did for the 12 months ended June 30, analyst Aye Soe found that indexes were clear winners. Only 40 percent of the funds that picked large company stocks were able to beat the indexes. Among those picking smaller stocks, the results were even worse: Only 31 percent of the fund managers produced gains better than the index.

"The performance figures are equally unfavorable for active funds when viewed over the three- and five-year horizons," Soe said. For the last five years, only 28 percent of U.S. funds with professionals at the helm were able to do better than the S&P Composite 1500 index.

gmarksjarvis@tribune.com

Twitter @gailmarksjarvis

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