Academic journal article Journal of Applied Finance

Market Efficiency and Diversification: An Experiential Approach Using the Wall Street Journal's Dartboard Portfolio

Academic journal article Journal of Applied Finance

Market Efficiency and Diversification: An Experiential Approach Using the Wall Street Journal's Dartboard Portfolio

Article excerpt

The concepts of market efficiency and portfolio diversification are easy to understand, but it is difficult for some to comprehend the relation of risk and return. A good way to teach these concepts uses the Wall Street Journal's dartboard contest, where dart throws and professionals pick only four stocks per period. Undergraduate students can use the contest to form portfolios: calculate returns, wealth changes, and risk measures; and compare results to unmanaged indexes over time. Doctoral students can use the contest to estimate a market model to calculate abnormal returns and announcement effects, and adjust for time series issues. Dart picks beat the pros over the 1990-2001 period on both on a cumulative wealth and risk-adjusted basis. Neither dart nor pro picks beat the S& P 500 or the DJIA on a raw return basis, and both fall well behind on a risk-adjusted basis. Analysis like this can enhance student understanding of the basic issues in market efficiency, diversification, and portfolio theory. [G110, G140]

For advanced undergraduate and MBA students, the concepts of market efficiency and portfolio diversification seem easy to understand. Many students grasp the broad effects of a lack of diversification, but cannot comprehend how a lack of diversification can impact stock returns and risk in a portfolio. Similarly, many students think that markets are efficient to some degree, but believe that: 1) professional money managers can on average beat the market, and 2) research and analysis can identify undervalued securities, technical trends, momentum, or other factors that can create consistent abnormal performance.

We can all cite research to support the claims of market efficiency. Literally thousands of studies investigate market efficiency. In the May 2001 version of EconLit, we find over 3800 articles including the words "market" and either "efficiency" or "efficient" in the text or title. For example, a professor may cite early work by Fama (1970) as evidence that markets are efficient. Fama (1998) indicates findings of anomalies or inefficiency are typically because of measurement problems or risk differentials. Then there are other results that question the efficiency of stock markets, such as Haugen and Baker (1996).

Grinblatt and Titman (1992) and Elton, Gruber, and Blake ( 1996) provide evidence that mutual fund returns are somewhat persistent, and that managers have momentum or "hot hands." Carhart (1997) finds that mutual fund performance results in these studies are due mostly to common factors such as size and bookto-market valuation instead of performance persistence. Authors test many anomalies that seem to refute market efficiency ranging from the January effect to the "Dogs of the Dow."

The common thread in all this work for students seems to be irresolution. The ambiguity in market efficiency and mutual fund performance research confuses students. For many, authors seem to argue more about statistical problems of various types and survivorship bias than the core issues of market efficiency, performance, or diversification. A better way to illustrate the effects of market efficiency and the performance of market professionals is through a project that aids comprehension. Students might track performance of publicly available professional recommendations against unmanaged indexes.

An alternative to teach students about stock market investing is an investing simulation game. Investment games requiring students to manage a hypothetical portfolio suffer from academic term time limitations. McClatchey and Kuhlemeyer (2000) report typical survey responses from investment professors: "Trading games are too short to get a feel for managing portfolios....The methods that you use to do well in a 3-month game are not the methods that you would employ over a 5-10 year holding horizon.... No matter how realistic the trading, the investment horizon is too short to be educationally valuable. …

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