S FUND MANAGER OF LEGG MASON VALUE TRUST,
William H. Miller had built a reputation as one of the world’s
savviest investors. Miller’s fund outperformed the overall market
every year from 1991–2005, a winning streak no other fund manager came
close to matching. But in 2007–2008, Legg Mason Value Trust fell by nearly
65%, almost twice as much as the broader market. As a result of this per-
formance, investors in the fund since 1991 effectively gave back all of the
gains they had earned relative to the market in the intervening years and
Miller’s reputation lay in tatters. Was Miller’s performance prior to 2007
merely luck or was his performance in 2007–2008 the aberration?
According to the CAPM, the market portfolio is efficient, so it should
be impossible to consistently do better than the market without taking on
additional risk. In this chapter, we will take a close look at this prediction
of the CAPM, and assess to what extent the market portfolio is or is not
efficient. We will begin by looking at the role of competition in driving the
CAPM results, noting that for some investors to beat the market, other
investors must be willing to hold portfolios that underperform the market.
We then look at the behavior of individual investors, who tend to make a
number of mistakes that reduce their returns. But while a few professional
fund managers are able to exploit these mistakes and profit from them, it
does not appear that much, if any, of these profits makes it into the hands
of the investors who hold their funds.
On the other hand, we will also consider evidence that certain invest-
ment “styles,” namely holding small stocks, value stocks, and stocks with
high recent returns, perform better than predicted by the CAPM, indi-
cating that the market portfolio may not be efficient. We explore this evi-
dence, and then consider how to calculate the cost of capital if indeed the
market portfolio is not efficient by deriving an alternative model of risk—
the multifactor asset pricing model.
portfolio weight of
return of stock or
risk-free rate of interest
alpha of stock
beta of stock
residual risk of stock
T. Lauricella, “The Stock Picker’s Defeat,”
Wall Street Journal
, December 10, 2008.