This post is a review of the scholarly article The ‘Noisy Market’ Hypothesis by Jeremy Siegel published in The Wall Street Journal (2006).
The article’s main point is that investors should explore the idea of constructing fundamentally-weighted indexes ( based on dividends, sales, etc) instead of market capitalization (which is how most major indexes such as the S&P 500 are weighted).
Siegel believes that capitalization-indexing has been one of the great innovations of the last few decades and that it has greatly benefited investors. It has allowed retail investors to gain market returns at a very low cost. However, Siegel believes that we can do better.
The first flaw of capitalization-indexing is that it is based on the Efficient Market Hypothesis. This hypothesis states that the price of a security reflects all the information available about that security and that it is the best estimate of the true underlying value of the firm. However, studies by academics such as Eugene Fama and Ken French has shown that there are problems with the Efficient Market Hypothesis (for a more detailed review of their seminal work, refer to the following article: “Size and Book-to-Market Factors in Earnings and Returns” in the Journal of Finance).
Second, security prices are influenced by speculators and momentum traders. Institutional buying and liquidity trading (when an investor wishes to adjust the risk of his portfolio or wishes to reduce or increase the size of the portfolio) can also affects prices. In general, Siegel concludes that security prices s are subject to shocks (which he calls ‘noise’) which obscures the true price of a security.
Therefore, with capitalization-indexing, you overweight over-priced securities and underweight under-priced securities. In order to eliminate this problem, Siegel recommends a new way of indexing, which is called fundamental-indexing.
Fundamental-indexing requires that you index according to a fundamental metric such as sales or aggregate dividends. Seigel states that dividend weighted indexes outperformed capitalization-indexes “by 123 basis points from 1964-2005 and with less volatility“. It has also been shown that dividend indexes fall by a smaller amount in market downturns.
Overall, it may be that indexes based on fundamental metrics may be a better way of creating your portfolio for the long run.
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Nice writing. You are on my RSS reader now so I can read more from you down the road.
Allen Taylor