Investments, tenth edition

  The Magnitude Issue   

We noted that an investment manager overseeing a $5 billion 

portfolio who can improve performance by only .1% per year will increase invest-

ment earnings by .001  3  $5 billion  5  $5 million annually. This manager clearly would 

be worth her salary! Yet can we, as observers, statistically measure her contribution? 

Probably not: A .1% contribution would be swamped by the yearly volatility of the 

market. Remember, the annual standard deviation of the well-diversified S&P 500 index 

has been around 20%. Against these fluctuations, a small increase in performance would 

be hard to detect. 

 All might agree that stock prices are very close to fair values and that only managers of 

large portfolios can earn enough trading profits to make the exploitation of minor mispric-

ing worth the effort. According to this view, the actions of intelligent investment managers 

are the driving force behind the constant evolution of market prices to fair levels. Rather 

than ask the qualitative question, Are markets efficient? we ought instead to ask a more 

quantitative question: How efficient are markets?