Bernard Baruch and J.M. Keynes are outstanding examples from an era when institutions were not set up in such a way that talented investors rapidly reached ...
Copyright
·
The Financial Analysts Federation. 1979
Reprinted from financial Analysts Journal. November1December 1979-all rights reserved
by Herbert G. Grubel
The Peter Principle and the
Efficient Market Hypothesis .. While Paul Samuelson concedes that "perhaps there are managers who can outperform the market consistently," he questions why academic investigators have been unable to find any evidence of
HE efficient market hypothesis, together with T
the empirical tests establishing its validity. rep resents one of t he most important achieve
ments in finance during the 1960s. The theory has
their existence. Professor Grubel suggests that the
received widespread public attent.ion and has un
answer may lie in the Peter Principle.
doubtedly influenced the behavior of many investors.
When a portfolio manager has investment
In fact. evidence suggests that investors who believe
success with a particular portfolio, it often presents him
in the efficient market hypothesis are less willing to
with opportunities to manage different and larger
follow professional investment advice, avoid turn
portfolios. So long as he continues to succeed, he will
over of their holdings and entrust less of their wealth
continue moving from one portfolio to another. larger
to paid managers of mutual funds and other imper
portfolio. Ultimately, he will confront a portfolio so large
fectly diversified portfolios.'
that his talents are taxed to the limit; having reached his level of "incompetence," he will no longer be able to achieve above-average returns.
Analysts and portfolio managers. having seen the great prestige and incomes they enjoyed during the 1960s fall dramatically during the 1970s (though prin
In a world in which recognition for success comes
cipally for other reasons). have engaged in many
rapidly, portfolio managers rapidly reach their levels of
debates about the merit of the efficient market
incompetence and tend to remain there for some time.
hypothesis with its proponents from the academic
Thus. at any given moment. only a small proportion of
world. The academics tended to win these arguments
all portfolio managers will be earning consistently
easily by pointing t o the strong evidence that mutual
above-average returns. And they will move through the
funds on average earned a rate of return that was only
successful portfolios of their careers so quickly that
equal to that of the market as a whole, and that
their existence will not really be visible to the tests of
individual funds traced through time did not succeed
academics.
in earning above-average rates of return for more than
If this hypothesis is correct, a successful portfolio manager should produce longer runs of above-average returns if he persists in managing
a very few years. Against these statistics. members of the investment community can offer only casual evidence and a be
small portfolios than if he moves on to larger portfolios.
lief that some professionals. who are better analysts
More generally, because the successful portfolio
than others. produce above-average yields for the
manager tends to change jobs frequently, any proper
portfolios they manage. This view has been spelled
test of his existence requires analysis of the
out by Arthur Zeikel: ··in any group of people ...
performance history of the manager, rather than the
some will exhibit the capacity to recognize and use
performance history of the portfolio. Do
infom1ation faster than others. and that capacity puts
Herben Grubel is Professor of Economics at Simon Fraser Uni1·ersiry, Burnaby. Canada. He thanks Stephen Easton. John Herzog and his former
them at a competitive a d v antage. Professional portfolio managers are paid to exhibit that capacity on behalf of clients and customers." It follows that "the
colleagues at the Finance Depanment of-rhe U11i1•ersity of Pe1111sylrnnia. Pao Cheng, An/111r Zeikel a11d Paul Samuel son for their helpful comn111ms.
I. Footnotes appear at end of amclc.
market is not totally efficient in its response to new developments. New and important information sim ply is not available simultaneously to all who might recognize or use it. Not all who recognize it are able to use it efficiently. "2 Paul Samuelson concedes that .. perhaps there real ly are managers who can outperform the market consistently-logic would suggest that they exist." But he goes on to ask why investigators-like Irwin Friend, William Sharpe, Fischer Black and Myron Scholes-have been unable to find such managers. "3 This article argues that investigators have not found evidence of especially talented professionals outper forming the market consistently in part because they
would act upon it. The resulting share price of Polaroid would be efficient in the usual sense that past price behavior contained no systematic clues about future prices and in the broader economic sense that no analyst could invest in further research and expect the benefits to exceed his costs. Enter Peter the Wizard, who has special talents in interpreting information. According to the story re lated to me as true by a Wall Street analyst, Peter had an intuition about the amount of film bought by the average new owner of the camera. With the proper amount of secrecy, he invested in the commission of a consumer survey of the buying habits of new camera owners. This survey revealed that the market price of
have not asked the correct questions and have used
Polaroid stock was too low. Consequently Peter, who
false data.
was managing a portfolio that was not yet large, purchased a number of shares, influencing the market
Talented investment analysts who can consistently outperform the market typically have high job mobil ity, appropriate a large share of their talents in the form of rent and, more or less quickly, become vic
price only marginally but increasing the return on his portfolio significantly above average, since the con
tims of the Peter Principle.• To discover the statistical
sumer survey eventually proved to be correct, and Polaroid's earnings and the price of the stock rose to
existence of exceptional investment talent, one must
the level predicted by Peter.
analyze the performance records of individual mana gers through their professional careers, rather than portfolio performances divorced from the records of individual managers.
Peter's Ability and Conventional Efficient Market Tests Episodes similar to the one above are, of course,
This article does not include any empirical evi
not inconsistent with the efficient market hypothesis:
dence on the performance of individual investment
it is an observed fact that, in every time period, some
managers through time simply because the necessary
portfolios show above-average rates of return. The efficient market model assumes, however, that such
data were unavailable. (Jn fact, my hope is that people with access to the relevant data will make them avail
successes are the result of luck and represent random
able to me or undertake the empirical analysis them
events. 6 Peter, according to the efficient market
selves.") The article begins with a general description
hypothesis, should not be able to repeat his perfor
of the special talents that would characterize gifted portfolio managers, then explains why conventional
sive periods. Empirical studies o f individual
studies have not been able to discover evidence of the existence of such managers. It concludes with a de scription of a more abstract model and suggestions for testing it.
A Description of Peter's Ability To describe precisely the characteristics of a financial
mance for a statistically significant number of succes portfolios through time apparently support this view. In its simplest version, the new model 1 propose suggests that Peter can and does use his wizardry to produce above-average yields for a statistically sig nificant number of periods in succession, but that his successes do not show up in conventional empirical tests for two reasons. First, Peter's very success con tinuously exposes him to offers to manage different
analyst with special abilities, whom we may call Peter the Wizard. assume that financial analysts other than
and larger portfolios, hence he tends to change jobs
Peter operate at a standard level of ability and operate
frequently. The proper test of Peter's existence there
efficiently, as implied by the most common form of
fore requires analysis of the performance of portfolios
the efficient market model. In such a world, the price
managed by him through his lifetime. Second, as
of Polaroid stock at all times would be efficient. For
Peter's reputation increases, so does his compensa tion and the size of the research staff he directs. These
example, announcement of plans to market a new, improved camera would impel analysts to invest in
outlays represent a cost of managing a portfolio and
research about past sales of cameras and film, general
are deducted from the portfolio's gross earnings to derive the net income that underlies most studies of
economic conditions. key personnel and many other elements considered relevant to the estimation of in vestment value. These analysts would very quickly
the efficient market model. This suggests any analysis of the performance of portfolios managed by Peter
reach a consensus abo�t the proper implications of all
should be based on yields before, rather than after,
this information for the value of the firm's shares and
adjustment for expenses.
We can extend this basic notion by applying the
limit.
In the real world, of course, investment
original Peter Principle. Peter the Wizard probably
analysis talent is likely to be normally distributed,
started out showing exceptional talents as a broker
like all other talents, and persons whose names have
working for some large firm and dealing with custom
entered history books represent the upper end of the
ers coming into the office on their own. When his
distribution and can be expected to be rare.
advice turned out to be better than average. he ac
In sum, the efficient market model can accommo
quired a growing number of regular clients. and the
date the possibility that portfolio managers differ ac
value of the total assets he directly or indirectly man
cording to their abilities to discover investment op
aged increased. As his reputation and income con
portunities , with some producing consistently
tinue to g row, he will be offered jobs managing in
above-average yields on the portfolios they manage;
stitutional portfolios of increasing size.
but such managers are discovered quickly, and the
Finally, however, Peter must confront a portfolio so
resultant flow of funds into their portfolios, together
large that his talents are taxed to the limit and the
with increased costs associated with increases in their
number of situations where he can successfully invest
research expenditures, occur so rapidly that empirical
additional research funds for above-normal yields be
studies have been unable to identify them.This article
comes too small to permit above-average returns for
maintains, however, that there are good reasons for
the entire portfolio. In other words. Peter sooner or
believing that the discovery of and reaction to such
later reaches his level of" incompetence." In a world
exceptional investment talent is not instantaneous,
where the process of reaching this level is rapid, and
hence that properly designed research should be able
tenure in the equilibrium position long, we would
to establish the existence of such individuals.
expect to find at any given moment only a small
Some Ideas on Testing
proportion of all managers on their disequilibrium path, earning consistently above-average returns. This may explain why, as Samuelson put it, these exceptional talents are "remarkably well hidden. "7 Proponents of the efficient market model would argue that rare investment talent tends to be discovered quickly and, in the terminology used here. moves through a disequilibrium path to equilibrium so quickly that its existence is not really visible. But the existence of the talent and its rate of movement should be susceptible of empirical demonstration. Samuelson explains why Peter's movement towards his level of incompetence is not instantaneous: .. From the nature of the case. there must always be a measure of uncertainty and of doubt concerning how much of one's money one can entrust to an
The preceding analysis can be made more rigorous with the help of a diagram suggested to me by Pao Cheng. In Figure I, the vertical axis measures port folio returns and the horizontal axis portfolio size. The rate of return Rm is that of the market average.
The line PP', which we might call Peter's Path, shows the functional relation between size and average per formance of portfolios managed by Peter. With a portfolio of size A. Peter is able to earn on average a (risk-adjusted) return equal to R
�
.
As portfolio size
increases, however. Peter's Path pproaches the mar ket average.
The line JJ' shows John's path, reflecting the in vestment analysis talents of another wizard.
As
drawn, John's abilities are superior to those of Peter,
adviser suspected of having an exceptional tal ent.... It is a mistake to think that so much
money will follow the advice of the best talents inevitably, as a
matter of the
logic
of competitive
Figure I
arbitrage alone. to leave ...every security with
the same expected variability and with the same
J
expected return."" The reasons for the uncertainty arc fairly obvious. Even
under efficient market conditions some
portfolio will show performance above the average. But the investor has no way of knowing whether this performance is due to the random luck of a Peter in equilibrium or to the talent of a Peter on a disequilib rium path.Only time and experience can tell. History does provide examples of rare talents en joying persistent investment succees. Bernard Baruch and J.M. Keynes are outstanding examples from an era when institutions were not set up in such a way that talented investors rapidly reached their Peter
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since at any given portfolio size, he is able to produce a superior perfornrnnce. The paths of John and Peter are representative of a whole family of varying in vestment talents. talents that, I ike most human
abilities, will be normally distributed. While the paths may not all be parallel or asymptotic to the market path, it will probably be·convenient to assume that the family of paths has some statistically conve nient properties. Given the life histories of a number of portfolio
3. P.A. Samuelson, "Challenge to Judgment," The Jour11al of Portfolio Ma11agement, Fall 1974, p. 17.
4. The Peter Principle in its original formulation states that individuals in any job who produce work of outstanding quality tend to be candidates for promotion to positions of higher responsibility demanding greater skills. Such promotion continues until individuals have reached po sitions in which their capacities are taxed to the limit so that they perform no more than average quality work. As a result of the operation of this principle we find that most jobs in the world are performed by persons who are
managers, particularly information about their in
just competent to do average quality work. This, in the
comes and the returns, variances and sizes of the
view of the authors of the Peter Principle. often implies
portfolios they have managed. a random walk model would permit specification of the length of runs of risk-adjusted returns above normal that normal indi viduals could expect in an efficient market. Then, if the data show persons who have produced runs longer than those expected from a purely random process, we would accept the hypothesis about the existence of
that the work is done "incompetently." See L.J. Peter and R. Hull, The Peter Principle (New York: W. Mor row and Company, 1969).
5. My colleague John Herzog and I have made some efforts
to generate a data base through a survey of Canadian portfolio managers. However, preliminary results are discouraging because the data requested are very per sonal and involve confidential relations with wealth
wizards. Indexes of wizardry could be developed to
holders. which many people apparently are unwilling to
test whether the distribution of talent is indeed nor
reveal for personal reasons or because of potential· loss
mal. The importance of portfolio size could also be tested. If our hypothesis holds, a person of a given quality of talent should produce longer runs of above-average yields if he persists in managing small portfolios than if he moves into larger portfolios. Of course, most of the arguments presented here are empirically unverified, although writings support the theoretical approach and imply that, ultimately, the existence of investment wizards can be an empiri
of confidentiality. However, there may exist somewhere a set of biographic data collected by a professional association or a government agency that could be used for the purpose of the proposed study. Alternatively, some such institution may be encouraged to add relevant questions to one of its routine surveys. It would seem very much in the interest o f the investment industry to test the proposed model and to attempt a scientifically designed reconciliation of the broadly held views of the members of the industry with the evidence on the effi
cal question. Given my inability to discover or gener
cient market hypothesis produced by academic inves
ate data for such an empirical study, this article re
tigators.
mains basically a theoretical exercise. But it is open to empirical testing by someone with the relevant data. As Samuelson said, in the contest between academics and practitioners over the validity of the efficient market model. the ball is in the court of the practition ers. It is up to them "to dispose of the uncomfortable brute fact [of empirical evidence that markets are efficient] in the only way that any fact is disposed of-by producing brute evidence to the contrary. "9 Bl Footnotes I. Arguments along these lines have been made by Fischer
6. P. Samuelson has dealt with the problem that prices of assets are, according to economic theory, determined by real forces in a theoretically predictable way. Therefore, their movement through time cannot follow entirely a Martingale process, since this implies that asset prices essentially would be indeterminate and independent of real economic forces. In "ls Real-World Price a Price Told by the Idiot of Chance?" (Review of Economics a11d Statistics. February 1976) Samuelson summarizes and
extends earlier work showing that prices anticipated properly according to real factors still fluctuate ran
domly. Yet, the fact that prices in the longer run are
determined by real forces does seem to give rise to the
Black. "Can Portfolio Managers Outrun the Random
opportunity for earning extraordinary profits from the
Walkers?" The Journal of Portfolio Ma11agement. Fall
correct forecasting of the influence of such real factors
1974 . He argues that portfolio managers should attempt less to forecast prices than to diversify portfolios co achieve optimally desired leverage and risk. 2. A. Zeikel. "The Random Walk and Murphy's Law," The Journal of Portfolio Ma11agement, Fall 1974, p. 21.
on prices. even though tests of short-run tluctuations show them to be random. 7. Samuelson. "Challenge to Judgment," p. 17.
8. Ibid .. p . 19. (Italics in original.) 9. Ibid.
