6: So, Just Beat The Market!

Confronted with the depressing facts about real market returns, the natural reaction is to say, “Well, then I’ll just beat the market.”  How will you do this?  You’ll buy winners and sell dogs.  How will you do that?  You’ll find a crackerjack broker to funnel you a steady stream of “tips”—or you’ll just watch CNBC, scour financial statements, and do it yourself. 

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And maybe you will.  Half a century of performance data suggests that a handful of investors with exceptional dedication, information, and skill can indeed pick stocks well enough to beat the averages over the long term (many do it over the short term, but this is usually the result of luck or the vicissitudes of investment style, not skill).  If you truly dedicate yourself to the task, therefore, you might succeed.

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The same half-century of evidence, however, suggests that you almost certainly won’t.  Instead, like most investors, including professionals, you will probably just waste money and time.  Importantly, if you do fail to beat the market, it will not be because you are incompetent or stupid.  One dangerous misconception about investing is that the reason most investors lag the market is that they are morons.  The real reason is that beating the market is hard.  (Another dangerous misconception is that intelligent investors should try to beat the market.  On the contrary, most should begrudgingly accept the market return.)

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Before continuing, we need to step back a bit, because if your friends or advisors haven’t seen the light on this, they will bludgeon you with a thousand examples of funds that have “beaten the market” over such-and-such a period.  They will also probably announce that they routinely beat the market.  And in the name of Wall Street self-defense, you need to know why they are usually wrong

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Active vs. Passive Management.

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Most investment strategies fall into one of two camps: Those that try to beat the market (or subset of a market called an index) and those that don’t.  The former, called “active” strategies, employ a variety of techniques—stock picking, market timing, fund picking, sector picking—to try to beat the averages.  “Passive” strategies, meanwhile, buy and hold all (or a representative sample) of the securities in an index, regardless of market conditions, with the aim of capturing the market or index return. 

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Importantly, passive investing does not just mean buying an S&P 500 index fund.  Markets can be segmented into dozens of indices, and passive strategies can be designed to track any of them.  Some of these indices, moreover, screen stocks by size, book value, earnings, price, and other fundamental metrics that most investors associate with traditional stock-picking techniques.  As passive investing has become more refined, in other words, the distinction between active and passive has become less clear-cut.  At the most basic level, however, an active investor will try to “pick winners,” while a passive investor will just aim to capture an index return.

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Most investors are active investors.  Why?  Because, at first blush, active management seems by far the superior strategy.  Who wouldn’t want to own just winners?  Who wouldn’t want to dump dogs?  Who wouldn’t want to get out before market crashes and in before market booms?  Who wouldn’t want to own a fund managed by “the next Warren Buffett”?  Answer?  No one.  As a result, most investors (or their advisors and fund managers) trade incessantly, with the aim of producing an above-market return.

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Not all active investors realize that they are trying to beat the market.  Some think they are just “investing.”  The only reason to practice active management, however—the only reason to pick stocks, time the market, buy actively managed funds, etc.—is to try to beat the market.  There was a time when advisors and fund managers could imagine that their job was to merely help clients “make sound investments,” but that time is gone.  The proliferation of low-cost index funds, life cycle funds, and other passive vehicles has made it easy and cheap for any investor to get near-market returns.  Anyone who chooses an active strategy over a passive one, therefore, is—knowingly or unknowingly—trying to beat the market

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What “Beating the Market” Means

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Any intelligent discussion about beating the market has to start with a definition of what the phrase means.  One popular definition is “beating the S&P 500,” a broad index of large US stocks.  For some investors, the S&P 500 is a meaningful benchmark with which to evaluate portfolio performance.  For others, however—such as those who trade small stocks—it is not.  Even when the S&P 500 is the appropriate benchmark, moreover, comparing relative performance is only meaningful when one also considers relative risk.

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For an investment to be worth making, it must have an expected return that compensates for its risk.  A stock that offers the expected return of a Treasury bill would be a bad investment.  (Just buy the safer Treasury bill.)  A Treasury bond that paid real interest of 7% per year, meanwhile, would be a great investment (equity-like returns with lower risk).  Thus, for an investor benchmarked against the S&P 500, the relevant question is not just “Did she beat the S&P” but “Did she beat the S&P while taking the same or less risk?”  Similarly, a better definition of “beating the market” is either: 1) generating a better risk-adjusted return than an index by picking winners, or 2) generating the index return with lower risk

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Welcome to a Zero-Sum Game

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The most important thing you need to know about trying to beat the market is that, unless you possess truly superior skill, the odds are against you.  If, like most people, you have made money in the markets, this is hard to accept.  It is true, however.  In aggregate, active-management returns will lag market returns, and the average active investor will lose.

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Judging by the number of commentators who express surprise, dismay, and/or scorn about manifestations of this sad fact—such as the observation that most professional fund managers fail to beat index funds—it is not widely understood.  It is therefore worthy of a detailed explanation.  There are two reasons why active management returns will always lag market (and low-cost passive) returns.  First, the aggregate gross return of all investors who trade within a market must equal the return of the market.  Second, active investors incur return-reducing costs that the market does not.[1]  

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This does not mean that the market can’t be beaten.  Each year, about half of the stocks in the market usually beat the market, and active managers who own more of these stocks than laggard stocks beat the market. (Whether they do this because of skill or luck is a different question, as is whether they will beat the market again next year.)  What it does mean is that, taken together, the performance of all active managers can be no better than the market return.  It also means that, after their costs are deducted, again in aggregate, active investors will do worse than the market return. (For a detailed example, please see the Notes.) 

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Before fees and costs are considered, in other words, active management is a zero-sum game.  After fees and costs are deducted, moreover, active management is less than a zero-sum game.  Specifically, it is a game in which the expected outcome is negative, in which the odds are against the average participant winning.  While some active managers will win, the majority will lose[2].

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[1] Nobel Prize winner William Sharpe explains why in a short essay called “The Arithmetic of Active Management.”  The gross return of a passive benchmark containing every stock in a market must equal the gross return of all active funds trading the stocks in the market.  If it does not, the sum of the passive returns plus the active returns would exceed the market return.  Because active funds have expenses, moreover, and the passive benchmark does not, the collective return of the active funds will always be lower than that of the benchmark.  The only way that active mutual funds can, in aggregate, beat passive benchmarks is if there is another group of traders who are much less skilled than active fund managers (for example, individual day traders).  If the day traders do badly enough, the mutual funds might, in aggregate, do better than the passive benchmark.  On a gross basis, however, the return of all actively managed money cannot exceed that of the market as a whole. 

[2] Strictly speaking, it is the average actively managed dollar that must lose, not the average active manager. Because a handful of investors—the top 200 institutional managers—control a large percentage of actively managed dollars, it is conceivable that a majority of investors could win, even though the majority of actively managed dollars lost.  For this to happen, however, the top 200 institutions would have to perform worse than all other investors—a scenario that, given their awesome research and trading resources, experience, and skill, seems unlikely.

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