# When even the best are unlikely to win

Posted by TEBI on October 2, 2020

##### By LARRY SWEDROE

A wizard appears, waves his magic wand, and makes you the 11th best golfer in the world. Being the 11th best golfer in the world earns you an invitation to the annual Super Legends of Golf Tournament. That is the good news. The bad news is that only the ten best players in the world will get to compete.

To even the playing field, you are given a major advantage. The rules of the game are as follows: Each of the other players will play one hole at a time and then return to the clubhouse and report his score. No player gets to observe the others play (i.e., you cannot gain an advantage by watching the others play). After each of the other ten players completes the hole, you are provided with the option of choosing to play the hole and accept whatever score you get, or choosing to not play that hole and accept par as your score.

The first hole is a par 4. After each of the ten best players in the world has completed the first hole, you learn that eight of the ten took five strokes to put the ball in the cup — they shot bogeys. One player shot par, and the other scored a birdie, needing only three strokes to put the ball in the cup.

##### Do you play or not?

You now must decide to either accept par or play the hole. What is your decision?

The prudent choice would be to choose not to play, take par, and accept a score of 4. The logic is that while it was not impossible to beat par (one player did), the odds of doing so were so low (10 percent) that it would not be prudent to try. And by accepting par, you would have outperformed 80 percent of the best players in the world.

In other words, when the best players in the world fail the majority of the time, you recognise that it is not prudent to try to succeed.

##### Do you have an advantage?

The exception to this line of thinking would be if you could somehow identify an advantage you might have.

Let’s say, for example, that the ten best players had played in a rainstorm with 50-mile-an-hour winds, and you played the following day when the weather was perfect and the course was dry. Given that situation, you might decide that the advantage was great enough that the odds of your scoring a birdie (a 3) were greater than the odds of your scoring a bogey (a 5), or perhaps even worse. Without such an advantage, the prudent choice would be to not play.

##### What does this have to do with investing?

You might be wondering, what does this story have to do with investing? Consider the following. It seems logical to believe that if anyone could beat the market, it would be the pension plans of the largest U.S. companies. Why is this a good assumption?

— These pension plans control large sums of money. They have access to the best and brightest portfolio managers, each clamouring to manage the billions of dollars in the plans (and earn large fees). Pension plans can also invest with managers that most individuals don’t have access to because they don’t have sufficient assets to meet the minimums of those superstar managers.

— It is not even remotely possible that these pension plans ever hired a manager who did not have a track record of outperforming their benchmarks or, at the very least, matching them. Certainly they would never hire a manager with a record of underperformance.

— It is also safe to say they never hired a manager who did not make a great presentation that explained why she had succeeded and why she would continue to succeed. Surely the case presented was a convincing one.

— Many, if not the majority, of these pension plans hire professional consultants such as Frank Russell Co., SEI and Goldman Sachs to help them perform due diligence in interviewing, screening and ultimately selecting the very best of the best. And you can be confident these consultants have thought of every conceivable screen to find the best fund managers. Surely they have considered not only performance records but also such factors as management tenure, depth of staff, consistency of performance (to make sure that a long-term record is not the result of a few lucky years), performance in bear markets, consistency of implementation of strategy, turnover, costs, etc. It is unlikely that you or your financial advisor would think of something they had not already considered.

— As individuals, it is rare that we would have the luxury of personally interviewing money managers and performing as thorough a due diligence as these consultants. And we generally do not have professionals helping us avoid mistakes in the process.

— The fees the plans pay for active management are much lower than the fees individual investors pay.

So how have the pension plans done in their quest for finding the few managers that will persistently beat their benchmark? The evidence is compelling that they should have “taken par”.

##### Underperformance “a virtual certainty”

In his 2020 paper Institutional Investment Strategy and Manager Choice: A Critique, Richard Ennis found that public pension plans underperformed their benchmark return by 0.99 percent and the endowments underperformed by 1.59 percent. He also found that of the 46 public pension plans he studied, just one generated statistically significant alpha, compared to 17 that generated statistically significant negative alphas. He calculated that “the likelihood of underperforming over a decade is 0.98 — a virtual certainty”.

It is evidence such as this that led Charles Ellis to declare active investing a loser’s game — one that is possible to win but the odds of doing so are so poor it isn’t prudent to try.

Returning to our golf story, I hope you agree that just as it would be imprudent to try to beat par when 90 percent of the best golfers in the world failed, it would be imprudent for you to try to succeed if institutional investors, with far greater resources than you (or your broker or financial advisor), fail with great persistence.

Remember, Richard Ennis found that over the horizon of a decade, their likelihood of success was about 2 percent. The only reason for you to try for that birdie would be if you could identify a strategic advantage over those institutional players.

The questions you might ask yourself are:

— Do I have more resources than they do?

— Do I have more time to spend finding future winners than they do?

— Am I smarter than all these institutional investors and the advisers they hire?

Unless you look in the mirror and see Warren Buffett staring back at you, it doesn’t seem likely the answer to any of these questions is yes. At least, it won’t be yes if you are honest with yourself.

##### The moral of the tale

Wall Street wants and needs you to play the game of active investing. They need you to try to beat par. They know your odds of success are so low and it is not in your best interest to play. But they need you to play so that they (not you) make the most money. They make it by charging high fees for active management that persistently delivers poor performance.

The financial media also wants and needs you to play so that you “tune in”. That is how they (not you) make money. However, just as you had the choice of not playing in the Super Legends of Golf Tournament, you have the choice of not playing the game of active management. You can simply accept par and earn market (not average) rates of return with low expenses and high tax efficiency. You can do so by investing in low cost, “passive” investment vehicles like index funds and other funds that are systematic and transparent in implementing their investment strategies.

By doing so, you are virtually guaranteed to outperform the majority of both professionals and individual investors. In other words, you win by not playing.

This is why active investing is a loser’s game. It is not that the people playing are losers. And it is not that you cannot win. Instead, it is that the odds of success are so low, it is imprudent to try.

##### Entertainment value

The only logical reason to play the game of active investing is that you place a high entertainment value on the effort. For some people there might even be another reason: they enjoy the bragging rights if they win. Of course, you rarely, if ever, hear about it when they lose.

Yes, active investing can be exciting. Investing, however, was never meant to be exciting. Wall Street and the media created that myth. Instead, it is meant to be about providing you with the greatest odds of achieving your financial goals with the least amount of risk. That is what differentiates investing from speculating, or gambling.

Many people get excitement from gambling on sporting events, horse races, or at the casino tables in Las Vegas. Prudent individuals, however, get entertainment value from gambling by betting only an infinitesimal fraction of their net worth on sporting events, etc.

Similarly, even if you receive entertainment value from the pursuit of the “Holy Grail of outperformance”, you should not gamble more than a tiny fraction of your assets on active managers being able to overcome such great odds.

##### Want to read more of Larry’s insights? Here are his most recent articles published on TEBI:

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