Efficient Markets and Why Index Funds Work
The market portfolio, the efficient markets hypothesis and why you should invest in index funds.
Index investing relies on the idea that neither you nor well-paid investment managers can beat the market by picking individual stocks, so you should own them all.
This makes things much simpler for average investors. Rather than worry about which stocks to buy, investors can buy an index fund or two and call it a day. The whole market is known as the market portfolio. And according to decades of economic research, this is the ideal portfolio for the average investor, because it delivers the average performance of the market without the unnecessary risk of owning individual stocks.
The market portfolio consists of every asset weighted in proportion to its existence in the market. This means that because Apple represents approximately 5% of the entire U.S. stock market, 5% of the market portfolio would be composed of Apple. Likewise, Tesla would make up about 1.5%, as that is the current market weight.
The market portfolio delivers built-in diversification to investors. Theoretically, the market portfolio includes every investable asset, including stocks, bonds, real estate, collectibles and more. In practice, it’s most often used to approach investing in the stock market. Owning the whole market means you don’t have to review complex financial data to decide which stocks to invest in.
Owning the market portfolio through an index fund will give you the exact performance of the market minus the fees of investing and any tracking error — how far a fund deviates from its index.
A Crash Course on Efficient Markets
Research on the market portfolio traces back to work done by several academics in the 20th century. In 1952, Harry Markowitz developed Modern Portfolio Theory which emphasized diversification to reduce investment risk. MIT economist Paul Samuelson found in his 1954 thesis that stocks moved randomly. In 1964, William Sharpe developed the capital asset pricing model (CAPM), which priced assets based on their risk or volatility and identified a factor known as market beta to explain stock returns. In his 1964 paper, “The Behavior of Stock-Market Prices,” Eugene Fama found that stock prices were random and impossible to predict. And finally, his 1970 paper “Efficient Capital Markets” synthesized past ideas to form the efficient markets hypothesis (EMH).
The EMH says that the price of an asset reflects all available information and therefore, all stocks are accurately priced. This means that the price of a stock takes into account news about the company, earnings reports and any other relevant information. And if stocks are accurately priced, you can’t beat the market by picking individual stocks unless you take on much greater risk. The EMH suggests that rather than try to beat the market, investors should invest in a passively managed portfolio through index funds.
Not everyone agrees that markets are perfectly efficient. Active traders attempt to exploit what they believe to be inefficiencies in stock pricing to earn greater returns over the market. Value investors believe some stocks can be undervalued and that identifying and overweighting these stocks can produce higher returns.
The original CAPM model with its single market beta factor couldn’t explain the outperformance of small stocks and value stocks. So in 1992, Fama, along with Kenneth French, developed the three-factor model which added the size and value factors to explain this anomaly. They later updated their research in 2014 in the five-factor model to add the profitability and investment factors.
Investing based on factors isn’t exactly active, but it isn’t exactly passive either. It differs from active management in that fund managers aren’t picking stocks based on their whim or what they believe will happen in the future, but it differs from passive management in that it incorporates a systematic strategy to identify stocks with specific characteristics and overweight them.
There is some debate as to whether the outperformance of small and value stocks is compatible with the EMH. On the one hand, this outperformance seems to call into question the efficiency of the market. On the other hand, some contend that value stocks are simply riskier and that the excess return is a premium investors earn for the additional risk.
Beating the Market is Hard
Either way, the idea of efficient markets is purely theoretical — it’s a model to better understand markets rather than a hard reality of how markets actually function. But although there may be inefficiencies in the market that some traders can exploit, the market portfolio is generally efficient enough to render attempting to beat it through active management futile over the long term.
Most investors who attempt to beat the market overwhelmingly fail. This is true for individual retail investors, but also professional fund managers. A study by Morningstar found that over a 10-year period, only 23% of active funds managed to beat passive funds. If you can’t beat the market, it’s better to join it.
The benefit of owning the whole stock market is that you’re only exposed to the risk of the market rather than the idiosyncratic risk of individual companies. This means that if a company’s stock drops due to a CEO scandal or poor sales, your overall portfolio will experience minimal impact compared to if you were overweight that stock. The market portfolio achieves the ideal balance between risk and return.
The Miracle of the Index Fund
If you were investing more than 50 years ago, the market portfolio was practically unachievable. Not only were costs prohibitive, but no index funds existed yet. And the active fund management industry, which had the most to lose, pushed back against the academic research behind indexing.
The index fund was perhaps the greatest financial innovation of the 20th century, allowing millions of investors to capture the market portfolio — including the total U.S. stock market, the international market outside the U.S. and total bond markets — at minimal cost. Many investment companies today offer them, such as Vanguard, Fidelity and BlackRock.
Regardless of whether markets are completely efficient, most people are unlikely to beat the market over the long term by picking stocks. By keeping your portfolio simple, you can earn the average market return without putting your wealth at risk.