7: Meet Your Competition

If you are like most investors, your reaction to the idea that most active investors lose will be, “So what?  The odds are against success in many endeavors in life, and winners still win.”  If this is your attitude, you will get nothing but encouragement from Wall Street.  The “you can beat the market” story is not only extremely profitable for those who make a living by facilitating active management.  It is also a story you want to hear—you’re a winner!—and one that plays to your ego and the American dream of independence and self-sufficiency.

 

Your odds of winning the active management game are lousy.  But, still, you have a point.  The odds are also against building a successful company, opening a successful restaurant, or writing a best-selling novel—and this doesn’t (and shouldn’t) stop you from trying.  So if, after reviewing the evidence, you really believe that you can consistently outwit most investors, then try.  Better yet, go into the money management business, where you can make a fortune even if you fail.  Whatever you do, don’t buy the hogwash that beating the market is just a matter of reading some research, analyzing some financial statements, and picking stocks or funds in your spare time.

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To win the active management game, you have to consistently outsmart the vast majority of other investors.  Your relative skill, therefore, matters.  In this way, active management is actually different from most games in Las Vegas--craps, blackjack, roulette—in which your odds are always negative.  A better analogy for active management is poker.  In poker, the overall odds for the table are negative (because the house takes a cut of every pot), but the odds for the best players at the table are positive.  In poker, you can win if you are only average, as long as the other folks at the table stink.  An intelligent poker player, therefore, need not be confident that she is world class—just that she is better than the people she is playing against.

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Unfortunately, this is where the analogy ends.  In the global financial markets, there are no special tables for beginners, hobbyists, and suckers.  There is just one table, and, every time you sit down at it, you will be competing against the best players in the world.  True, you will also be competing with tens of thousands of boneheads.  But the majority of your competitors will be smart, experienced, well-trained, well-informed professionals who do little but play the game.[1]

 

Is it possible for you to beat these players consistently?  Yes.  Is it likely?  No.

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Your Competition

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If you play the active management game, your competitors will be all other active investors—including many who read the same research, use the same trading tools and services, and listen to the same experts as you do.  Most of these competitors will be full-time investment professionals with resources, contacts, information, and experience that you can only dream of.  These competitors will be working around the clock—and around the globe—seven days a week, with only one goal in mind: to kick your ass.

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Why?  Because that’s the only way they can win.  Remember that active management is a zero-sum game: Every above-market return earned by one investor must come at the expense of another.  For you to beat the market, you must consistently beat most of your competitors.  So it behooves you to have a good grasp of who they are.

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Your competitors include thousands of professionals employed at mutual funds, hedge funds, pension funds, trusts, banks, trading desks, brokerage firms, governments, and corporations who collectively manage tens of trillions of dollars worth of money worldwide, as well as millions of small investors who manage trillions more.  Do not delude yourself into thinking that, because there are more individual investors than institutional investors, you are competing against amateurs.  Professional investors manage the vast majority of money and conduct the vast majority of trades.  According to Charles Ellis, author of Winning the Loser’s Game, more than 90% of the trades on the New York Stock Exchange are made by professionals.  Chances are high, therefore, that the person buying from you or selling to you knows what he or she is doing.

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The skill and sophistication of your competitors varies, but, on the professional side, even the average ones have enormous resources.  For example, the average professional:

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• researches investments for at least ten hours a day.
• has access to every news story, blog, press release, financial filing, and company presentation ever published, as well as off-the-record commentary that is often far more revealing.
• spends thousands of dollars a month on primary research.
• has relationships with professional analysts at dozens of firms.
• visits dozens of companies a year.
• participates in hundreds of conference calls and investment conferences a year.
• has a Rolodex full of industry sources.
• has years of full-time money management experience.
• gets every Wall Street research report in seconds.
• gets daily calls from salespeople at thirty-odd Wall Street firms relaying every scrap of information, scuttlebutt, or rumor they hear.
• has phone numbers of CEOs, CFOs, etc., on his or her cell phone.
• and, yes, watches CNBC (often howling with laughter).

Are these professionals so talented and well-informed that they can’t be beaten?  No.  In fact, despite these advantages, more than half lose the active management game—usually to other professionals.  The efforts of all these professionals do, however, make it harder for you to win, a fact that you would be wise to keep in mind.

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Those who have a vested interest in your trading often imply that the reason most professionals lag the market because is that they are incompetent (implication: you can do better).  Sadly, this is absurd.  It is similar to suggesting that major league baseball players strike out a lot because they are incompetent.  Professional baseball players are not incompetent, and unless you’re willing to do the work necessary to become one, you almost certainly can’t do better.

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Three Advantages You Do Have

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Some good news:  If you invest intelligently, you will have three potential advantages over most professionals.  The first will effortlessly allow you to beat the majority of them.  The second and third might even, in rare cases, allow you to beat the market.

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Your first advantage—the only one you should embrace unless you are willing to devote your life to the task—is that you don’t have to try to beat the market.  Instead, you can just buy low-cost passive funds.  This will guarantee that you will beat most professionals, who are paid to try to beat the market and, therefore, can’t buy low-cost passive funds.  The most client-oriented move for most investment professionals would be to fire themselves and put their clients in index funds.  Few will choose this route.

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Does buying low-cost index funds sound like a cop-out?  Well, here’s another way of saying the same thing:  After more than a century of research, the world’s smartest investment gurus have finally figured out a simple, foolproof way for you to beat the pros.  You don’t need expertise.  You don’t need to spend time or money learning complex techniques.  You don’t have to buy software, hire advisors, or read research.  You don’t have to worry about making expensive mistakes.  You don’t have to read a single annual report, make a single forecast, or talk to a single customer or employee. The secret?  I could tell you, but then Wall Street would have to kill me.

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Your second advantage is size.  For two reasons, managing a small amount of money is often easier than managing a big one: You have more securities from which to choose, and your transactions will not move the market.  The manager of a massive equity fund must restrict purchases to large stocks, because small ones aren’t big enough to amount to a meaningful position of the portfolio.  Trading large blocks of stock, meanwhile, usually has an adverse impact on the price of the stock, thus reducing a fund’s return.  Small investors, in contrast, can buy or sell any stock in the market, and their transactions do not usually affect the price.

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Your third advantage is that, unlike most professionals, you do not have to answer to impatient, demanding clients and, therefore, do not have to focus on absurdly short time frames.  The investment business has become so competitive that managers are now held accountable for performance over weeks, months, and quarters.  A manager who under-performs over these periods will quickly get flak, and, if the under-performance continues, will soon get fired.  The relentless focus on short term performance forces managers to balance investment risk with business and career risk, and, in so doing, make low-percentage, short-term bets.  This behavior often reduce the manager’s odds of beating the market over the long term, and also generate increased transaction, research, and tax costs (thus hurting the client two ways).  The reality of the money management business, however, is that most clients focus on short-term performance, so most professionals must focus on short-term performance, or else risk damaging their businesses and careers.  You, on the other hand, have the luxury of being able to focus on the long term.

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A long-term focus lets you take factors like valuation and mean reversion into account.  Over short time frames, valuation—a stock’s price relative to the underlying company’s cash flows—has little impact on what the stock will do.  Over the long term, however, valuation matters.  Focusing on the long-term also allows you to reduce costs and stop worrying about what the market will do next (anyone’s guess).  It allows you to capitalize on opportunities created by the short-term behavior of most investors: You can buy cheap stocks that might take years to move, or sell expensive ones that might continue to soar for a while.  Just as important, it allows you to avoid competing with most professional investors by playing a different game—the one, not coincidentally, Warren Buffett plays.[2]    E

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Even with this advantage, beating the market will be hard enough that you would almost certainly be better off buying a passive fund.  But you will have a better chance than if you try to out-trade SAC Capital, Soros Fund Management, Fidelity, et al.

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So, yes, it is possible to consistently beat professional investors.  It is unlikely and difficult, however.  Most professional investors are not stupid or incompetent.  And, believe me, they will be very happy to compete against you.

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[1] Lest the poker analogy make you think that you just have to be better than most investors, Dartmouth professor Kenneth French adds a further insight.  If you sit down at a poker table at which you are better than five of the seven players, do you think the best two players, the ones who are better than all six of you, are happy or sad that you showed up?  Happy.  Your playing just means more money for them to win.

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[2] In part because Warren Buffett is CEO of his company, in part because he is not an employee at a mutual fund, and in part because is extraordinarily clear-headed, Buffett takes a longer-term perspective than most institutional investors.  This does not make him immune from bouts of crappy relative performance, or the criticism, frustration, and ridicule that inevitably accompany them.  It just means that he is less exposed to the career and business risk than many professionals.

Comments

[Gary Zuo]

Most of the professionals lose, even according to you. I feel most of them are no better than members of a herd, despite the resources.