There is a hoary old chestnut about the professor of economics walking through the City with a graduate student. They see a £20 note lying on the pavement across the street, and the student makes as if to cross the road to pick it up.
“Don’t bother,” says the professor. “It must be a fake. If it were real, someone would already have picked it up.”
This is the story Burton Malkiel told at a press breakfast this week to illustrate how simple his insight into investment success is. For 35 years, the Princeton professor of economics has been proselytizing for passive investment – the idea that statistically the sensible thing to do is just invest in the broadest possible basket of shares, weighted according to capitalisation.
In his story, presumably Prof. Malkiel plays the part of the ingenuous student whose simplicity could put him £20 up. Since the latest estimates are that just 30 per cent of US institutional assets and 10 per cent of retail assets in the US, where index investing has taken off most, are in index funds, the rest of the world stands in the place of the professor.
His theory rests on the efficiency of markets – but ignores the fact that those same markets are driven by the investors who stubbornly persist in believing active management can add value. This cannot be a rational belief if markets are efficient, but if it is irrational, the collective actions of the irrational investors are surely unlikely to add up to efficient markets.