Why beating the market is just a game of chance

The investing industry gives the impression that beating the market is all about skill, but the evidence tells us it's largely a game of chance

This is the third article in our 12-part series on Mark Hebner's "Index Funds: The 12-Step Recovery Program for Active Investors." Missed the previous steps? Catch up here on Step 1 and Step 2.

If Nobel Prize-winning research wasn't enough to convince you that active investing is futile, perhaps the brutal statistics on stock picking will do the trick. The evidence is stark: professional fund managers, with all their resources and expertise, perform no better than a blindfolded monkey throwing darts at a newspaper when it comes to beating the market.

The collective brain

Every trading day, approximately ten million investors trade ten billion shares worth about $750 billion. With each transaction, buyers and sellers aggregate their knowledge into what Rex Sinquefield calls a "collective brain" — a vast processing machine that compiles all knowable information into market prices.

As Sinquefield puts it: "You can have one individual who can be very, very smart and actually know a little bit more than everyone else. But does he know more than six billion people combined? No. He knows a tiny, tiny fraction of what is knowable and what is built into prices."

The devastating evidence on beating the market

Academic studies have systematically destroyed the myth of stock-picking skill. In 1968, Michael Jensen found "very little evidence that any individual mutual fund was able to do significantly better than that which we expected from mere random chance."

A comprehensive study of 2,076 fund managers over 32 years revealed that 99.4% displayed no evidence of genuine stock-picking ability. The tiny 0.6% who did outperform were "statistically indistinguishable from zero" - in other words, just lucky.

Even more damning, research by Terrance Odean showed that individual investors who traded most frequently earned just 11.4% annually while the market returned 17.9%. The stocks they bought actually underperformed the stocks they sold.

Information is "baked in the cake"

Stock pickers fail to realize that virtually all information about companies, sectors, and economies is rapidly processed by millions of market participants and embedded into prices. This market efficiency ensures that agreed-upon prices represent the best estimate of fair value.

Great companies ≠ great investments

Counterintuitively, buying shares in companies you admire is often a losing strategy. A study of Fortune's "Most Admired Companies" from 1983-2007 found that "spurned" companies (those with poor reputations) returned 16.12% annually versus just 13.81% for "admired" companies.

The market perceives distressed companies as riskier, driving down their prices and creating higher expected returns - exactly the opposite of what most investors assume.

Looking for a needle in a haystack

John Bogle's metaphor perfectly captures the futility of stock picking. Of the original S&P 500 companies from 1957, only 74 remained on the list by 1997, and just 12 outperformed the index over 41 years. The majority of individual stocks have delivered lifetime returns below Treasury bills.

The solution to beating the market isn't to search for needles - it's to buy the entire haystack through low-cost, globally diversified index funds that harness the collective wisdom of all market participants.

Learn more by reading or listening to Step 3 of Mark Hebner’s award-winning book Index Funds: The 12-Step Recovery Program for Active Investors here.

Next week: Step 4: why timing the market is so extraordinarily difficult

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