Joel Greenblatt (Trades, Portfolio) is a hedge fund manager and academic well known for his emphasis on value investing. He is the author of several books catered towards individual investors looking to beat the market. In this interview, he laid out his views on several important questions, namely: whether an individual can succeed when going up against institutions and whether the market is too short-term oriented.
Can the individual investor beat the big guys?
“As it turns out, the regular indexes - the S&P 500, or the Russell 1000 - are seriously flawed. Even though they beat most active managers, they’re still very seriously flawed. And they do something that costs investors about 2% a year. And that is that they’re market cap-weighted indexes...so if you believe like Ben Graham, or Warren Buffett (Trades, Portfolio), that the market is sometimes emotional, that it’s not efficient like so many professors have professed over many years, that means that if the market does get emotional over the short term, that some stocks are underpriced and some are overpriced.
And a market cap-weighted index, if a stock is overpriced, it buys too much of it, automatically, and if it’s underpriced it buys too little of it, automatically…So it sounds crazy, but it actually systematically is doing the wrong thing at every point, whenever there is an inefficiently priced stock.”
This isn’t to say that index investing is always the wrong move; in fact, Greenblatt said at a different point in the interview that indices outperform 70% of managers. But the key thing about indices is that they suffer from the systematic error of overweighting overpriced companies. This is distinct from the random errors that will occur in any portfolio as a natural consequence of variance and volatility in the markets.
Greenblatt’s point is that these systematic errors cost index investors around 2% in returns a year. Individuals should seek to counteract them by either following an active value investing strategy, or by buying equal-weight indices that do not suffer from the same systematic error.
Is the market too short-term focused?
“You would think that it would be getting tougher and tougher for individual investors to outperform the market [given the proliferation of computing power and information on Wall Street], and what it turns out is our simple value factors have actually gotten stronger over the last 20-30 years. And the reason for that is that the world has gotten a lot more institutionalised … People look at daily returns, weekly returns, monthly returns, they get analysis over the month or the quarter … four or five years is a more reasonable time frame to judge anyone’s performance.”
In other words, people chase performance based on short-term fluctuations in the market that cannot be reasonably attributed to anything other than statistical noise. This is precisely what causes inefficient pricing -- high-flying growth stocks end up being overvalued, while solid value propositions are undervalued because they do not demonstrate the strong daily or weekly gains that investors have come to expect. So in many ways the current short-termism is a benefit to the long-term oriented investor, as it creates a greater number of opportunities for them to exploit.
Disclosure: The author owns no stocks mentioned.
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