David R. Henderson  

Oops. My Apologies to John Bogle--and to Paul Samuelson

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David Henderson's "A Nobel for the Random Walk of Stock Prices" (op-ed, Oct. 15) describes me as "one high-profile beneficiary of Mr. Fama's insight," allegedly inspiring my founding of the Vanguard 500 Index Fund in 1975.

This is untrue. Perhaps to my shame, I didn't even learn of Eugene Fama's "efficient market hypothesis" (EMH) until a decade after my creation of the 500 Index Fund. Rather, I was inspired by another Nobel laureate, economist Paul Samuelson, who in his 1974 essay in the Journal of Portfolio Management demanded "brute evidence" that active money managers could beat the market index. Such evidence has yet to be produced.

Numbers-crunching economists like Mr. Fama represent the "quantitative school" of indexing who came to believe in stock-market efficiency. In fact, he inspired the founding of Dimensional Fund Advisors (DFA), which follows, not an indexing strategy, but a strategy based on persistent undervaluations of various market segments. Mr. Fama continues to serve on the DFA board.

The "pragmatic school" of indexing, on the other hand, simply amassed vast statistical evidence showing that the returns earned by active managers seldom outpace the S&P 500 Index. Further analysis showed that the failure of active fund managers was a result of the costs they incurred. The average manager is average, but only before all these fund operating expenses, advisory fees, turnover costs and sales loads. After those costs, active management becomes a loser's game. It is the "cost matters hypothesis" (CMH) that assures that investors in low-cost index funds win the battle for superior returns.


So writes John Bogle in today's Wall Street Journal, in response to my Tuesday piece on the Nobel laureates.

Come to think of it, when the late Armen Alchian taught us about efficient markets, he emphasized Samuelson over Fama. What can I say other than: I blew it.

BTW, here's my post on Samuelson after he died.

And here's the response I wrote to Mr. Bogle on the Wall Street Journal site:

Thanks for your correction, Mr. Bogle. My apologies for misrepresenting the source of your thinking. Also, thanks for setting up the fund. In my retirement investments, I've been a big beneficiary.


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COMMENTS (6 to date)
Daniel Kuehn writes:

And Samuelson rescued those points (which would eventually blossom into EMH) from a French economist in the 19th century, if I recall.

Some people expected Krugman to go nuts over this Nobel. Of course he didn't, and I think part of the reason why is that Krugman knows his Samuelson and Samuelson knows his economics. The recent spat with Fama over a very awkward rendition of the Treasury View has little to do with his contributions in finance, which were rightly acknowledged by Krugman as being deserving of a prize.

Now, whether we like Fama because we literally believe EMH or because we accept it as a first approximation for modeling purposes - the importation of rational expectations into finance - is a different question.

Daniel Kuehn writes:

http://en.wikipedia.org/wiki/Efficient-market_hypothesis#Historical_background

Yep - Louis Bachelier, and there was an even earlier contribution from Jules Regnault.

Also, don't forget the Russian economist Eugene Slutsky, nor Harry Roberts of Chicago, and a few others, in addition to Samuelson. I've forgotten the name of the guy who had a background in physics and upon seeing Bachelier's (1900) equation realized it was identical to Einstein's (1905)for Brownian Motion.

TMS writes:

Bogle gets it wrong here:

Fama inspired the founding of Dimensional Fund Advisors (DFA), which follows, not an indexing strategy, but a strategy based on persistent undervaluations of various market segments. Mr. Fama continues to serve on the DFA board.

DFA portfolios overweight small-cap stocks and value stocks not because Fama/DFA believe that these stocks are persistently undervalued, but because they believe that these types of stocks are riskier than the market as a whole and therefore have higher expected returns.

Brad writes:

So, why do active fund managers persist? Are they better at sales than at picking stocks? I think The Motley Fool fits this bill. They excel at selling their "proven" method for beating the market, but I suspect that few followers actually do, especially over the long run.

So, is Warren Buffet just lucky? With his method of investing, he rarely incurs costs, which boosts his returns.

Various writes:

I wouldn't worry about it. If you or anyone else were held to a standard of 100% accuracy with everything written, we readers of Econlog and the WSJ would be a pretty bored lot with little to read. 99 and 44/100 percent accuracy is plenty.

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