dollar-weighted performance of all investors, so that for anyone who
does better than the index, someone else must do worse. Second, these
portfolios, under certain assumptions, give investors the “best” trade-off
between risk and return. This means that for any given risk level, these
capitalization-weighted portfolios give the highest returns, and for any
given return, these portfolios give the lowest risk. This property is called
mean-variance efficiency.
But the assumptions under which this desirable property prevails
are very stringent. Capitalization-weighted portfolios are optimal only if
the market is efficientin the sense that the price of each stock is an unbi-
ased estimate of the true underlying value of the enterprise. This does
not mean that the price of each stock is always right; but it does mean
that there is no other easily obtainable information that allows investors
to make a better estimate of its true value. Under efficient markets, if a
stock goes from $20 to $25 a share, the best estimate of the change in the
underlying value of the enterprise is also 25 percent. There are nofactors
unrelated to fundamental value that could have changed the stock price.
But, as we learned in Chapter 9, there are many reasons why stock
prices change that do not reflect changes in the underlying value of the
firm. Transactions made for liquidity, fiduciary, or tax reasons can im-
pact stock prices, as well as speculators acting on unfounded or exag-
gerated information. When stock price movements can be caused by
factors unrelated to fundamental changes in firm value, market prices
are “noisy” and are no longer unbiased estimates of true value. I call this
way of looking at the market as the “noisy market hypothesis,” and I
find it an attractive alternative to the efficient market hypothesis that has
dominated the finance profession over the last 40 years.
If the noisy market hypothesis is a better representation of how
markets work, the capitalization-weighted indexes are no longer the
best portfolios for investors. A better index is a fundamentally weighted
index, in which each stock is weighted by some measure of a firm’s fun-
damental financial data, such as dividends, earnings, cash flows, and
book value, instead of the market capitalization of its stock.^19
Fundamentally weighted indexes work in the following manner.
Assume earnings are chosen as the measure of firm value. If Erepresents
the total dollar earnings of the stocks chosen for the index, and Ejis the
earnings from a particular firm j, then the weight given to firm jin the
index is Ej/E, its percentage share of total earnings.
354 PART 5 Building Wealth through Stocks
(^19) As a matter of full disclosure, I am the senior investment strategy advisor at WisdomTree Invest-
ment, Inc., a company that issues fundamentally weighted ETFs.