Beating the Market

Yesterday, we quoted a Globe and Mail article that commented on a book Zombie Economics: How Dead Ideas Still Walk Among Us by John Quiggin. (Click here for article). That quote read:

"Nothing in the (efficient market) hypothesis can explain the frequent bubbles and busts, strange stock valuations or the inconvenient truth that some shrewd investors do outperform the market." (emphasis added)

Our previous blog sought to illustrate that a "shrewd investor" could beat the market purely by luck. The evidence of investors outperforming the market is not sufficient to dispell the efficient market hypothesis. Today, we take a stab at what "outperforming the market" means, and what is should mean. By most accounts, beating the market implies creating a portfolio that generates a return, after transaction costs, that exceeds the return of a benchmark index i.e. TSX 60, DJIA, SP500, FTSE 100, CAC40, DAX, Nikkei, Hang Seng, MSWI etc.

There are some problems with this method, however, in that simply comparing the rate of return to a market index does not compensate for the risk of the portfolio. In general, the greater the risk, the greater the return. So, for  example, if we create a portolio using only the 30 riskiest stock in the TSX 60, we are likely going to beat the TSX.

There are at least three measures of return that do compensate for risk, and beating the market should be evaluated using one or more of these measures.

The Sharpe measure can be used for sufficiently diversified portfolios and is the ratio of the portolio return minus the risk free rate of return divided by the standard deviation of the portfolio return. This ratio is then compared to the same ratio for the benchmark. The Sharpe measure looks to see if the portfolio lies above or below the capital market line. Above indicates that the porfolio beat the market after compensating for risk.

The Treynor measure can be used for single securities as well as a portfolio and is the the ratio of the portfolio or asset return minus the risk free rate of return divided by the beta of the asset. Beta is a measure of risk relative to the market risk. The Treynor measure looks to see if the portfolio lies above or below the securities market line.

Finally the Jensen measure, or alpha, is similar to the Treynor measure in that is makes a comparison based on beta. Alpha is calculated by taking the difference between the actual rate of return of a portfolio minus the return predicted by the capital asset pricing model (CAPM). If alpha is positive the portfolio beat the market on a risk adjusted basis.

Yesterday, we showed that beating the market can be a matter of pure luck. Today, we showed that beating the market may be a result of taking on excess risk. Our intent is to show that having some shrewd investors that outperform the market is not sufficient to dismiss the EMH.