Much of the mainstream media commentary around investing carries with it the assumption that beating the market should be everyone’s goal. But what does that mean? And does it make any sense?
Essentially, the idea that ordinary investors can consistently do better than the market, after allowing for risks and fees, is a fanciful one. The truth is even the pros struggle to outperform the market year-in and year-out.
Of course, you will hear of outliers like Warren Buffett of Berkshire Hathaway or Peter Lynch of the Magellan Fund who seem to hold out hope that delivering market-beating returns for years is within everyone’s grasp.
But the record shows that most managers struggle to beat benchmarks over long time periods and that the winners don’t tend to repeat. And even allowing for manager skill, that still leaves investors with the challenge of finding the skilled ones ahead of the event.
Distinguishing luck from skill
Another issue for those of us trying to pick the best managers is separating out luck from skill. A famous academic paper in recent years looked at the performance of US mutual funds over 23 years and found few funds product benchmark-adjusted returns sufficient to cover their costs.
This isn’t to say there aren’t skilled managers. But think about this: If those managers do have sufficient skill to beat the market year after year, why would they not capture all those rents themselves? Why would they share it with the wider public?
In any case, what is advertised as skill is frequently just what is there for the taking. In recent years, what managers advertise as “alpha”, the skill that enables them to beat the market, has increasingly been exposed as beta – the return you can earn without trying to outguess the market.
The behaviour gap
But while the various camps in the asset management industry slug it out over how much value they add, the challenge for most investors is just getting the market rate of return. Studies like the annual DALBAR analysis of investor behaviour regularly find a significant gap between what the market offers and what average investors receive.
People underperform the market mainly because of their own behaviour. They are more sensitive to losses than gains, they chase past winners, they fail to sufficiently diversify, and they try, in vain, to time the market. They also ignore boring, but important, factors like costs and taxes.
A lot of this bad behaviour results from people thinking that their goal should be to “beat” the market when their real goal is to earn the market return and do it consistently and at low cost so that they maximise their chance of securing the long-term returns they need to retire on.
It doesn’t sound sexy, does it? But when investing starts to sound sexy is when the alarm bells should go off.
Short-term market movements are unpredictable
The fact is market returns are unpredictable. And that, in part, is because news is unpredictable. Economies are fluid; growth accelerates or slows; companies rise and fall; once dominant industries succumb to technological evolution; and consumer preferences are always changing.
Markets price all this news instantaneously, reflecting collective expectations for future returns. Trying to outguess the market means second-guessing those prices, which is a haphazard occupation at best.
You may, of course, be right, but you’re just as likely to be wrong. And remember, to outperform consistently you need to keep on making correct calls time and again, and hope that any gains you make at least offset the costs involved in active trading.
Follow Warren Buffett’s advice
Even Warren Buffett, the doyen of stock pickers, has argued that most people would be better off in a low-cost index fund. And he famously won a $1 million bet that these boring “passive” funds would do better than most expensive and elaborate hedge funds over a decade.
So, while the idea of beating the market is an attractive one, the reality is that most people are more likely to get “beaten up” by the market. And they do so primarily because of a refusal to just accept that prices, however imperfect, reflect the best available estimate of future returns.
Investing Fundamentals is a series in which we look at the basic principles underpinning successful investing. Here are some other recent articles in the series you may have missed:
Stock price movements: How predictable are they?
How much risk should you take?
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