Much of the media commentary around markets and investing positions the individual as a heroic figure, pitching his or her expertise against the views of everyone else. Beating the market wins you bragging rights. However, this framing is based on a number of myths.
The number one myth is that your job as an investor is to somehow outguess the market. This is the idea that the secret of investment success is to have rare insights and expertise not shared by anyone else, alongside nerves of steel and almost supernatural timing ability.
Supposedly “star” fund managers trade off this perception, promoting their expertise in picking tomorrow’s winners and selling the future losers ahead of the crowd. As we know now from painful experience, such stars tend to burn brightly before crashing to earth.
The fact is markets are highly competitive. Millions of participants, including armies of rocket scientists and savants, buy and sell securities every moment of every day in pursuit of an advantage. Algorithmic trading systems seek a timing advantage measured in micro-seconds.
What’s more, all the publicly available information — from earnings news to economic data to the published opinion of every stock analyst and economist — is already baked into prices. Outguessing the market requires, firstly, that you have profitable information that no-one else has and, secondly, that you can predict how the market will react. And remember, getting it right once is not enough. You have to do it over and over again.
So there is an element of Don Quixote in investors who imagine they have an elusive and mystical edge that nobody else has. In reality, those who go out every day, like the Man of La Mancha, with the intention of beating the market only risk making a fool of themselves.
Skill or luck?
Of course, there will always be individual managers who do better than the benchmark from year to year. But there is also plenty of evidence from academic studies that the winners don’t tend to repeat and that, in any case, it is hard to separate their advertised skill from luck.
As an example, Standard & Poor’s produces a regular scorecard comparing the performance of traditionally active managers against index returns. This consistently shows that most struggle to outperform common benchmarks over three-to-five-year periods.
For instance, in the five years to the end of 2019, more than 77% of European equity funds lagged the S&P Europe 350 index. Over three years it was closer to 80%. Even over one year, more than 70% of managers underperformed.
UK funds did better over one year at least. In 2019, 73% of active equity funds in this category beat the S&P United Kingdom BMI. But take the comparison out over 10 years and the proportion of UK managers beating the market, as defined by the index, was less than a third.
Here we come to a second myth — the charitable fund manager. Let’s just say you’ve decided you’re not going to put your money with index-lagging managers, but only with the stars. And let’s assume for a moment that you are able to pick the future stars ahead of time.
Now ask yourself: If these managers are so good, why would they share the additional value they capture with you? A gun stock-picker with the rare ability to identify winners year in and year out presumably will be charging a significant fee for his or her service.
Funnily enough, you’ll find that these additional fees typically absorb most of the additional return, or “alpha”, that these managers achieve due to their advertised skill.
Your own benchmark
The final myth is that your job as an investor is to hurdle an artificial benchmark. In truth, you’ll find some years that you’ll do better, while others, you’ll fall short, usually without any change in effort on your part. In any case, it depends on how your assets are allocated and within stocks, bonds, cash and property.
A better question is how your portfolio is performing on a risk-adjusted basis. How much return are you generating for the risk you are taking? For instance, if your portfolio is 40% in the safest government bonds in a year that equity returns outpace bonds, you are not going to do as well as someone who was 100% in equities that year. Likewise, in a bad year for equities, your portfolio is going to do significantly better than the other person’s.
Your real benchmark isn’t beating the market. It’s how you are performing relative to the goals set in consultation with your adviser. And that is going to be determined by your risk profile, your goals, your asset allocation, how diversified you are, fees, and ensuring you pay attention things you can control.
This approach may not sound as heroic and sexy as the image of the individual investor, bravely second-guessing the market, but it will almost certainly yield superior results in the long-term.
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