Want to Beat the Market? You’ll Need More than Luck

As investors may or may not know, there is a long running theoretical debate in the financial world surrounding a basic question:  Are there investors out there that can consistently “beat the market” (i.e. pick investments that outperform the broader market)?  If you are a faithful reader of my blog, you already know where I stand.  My take:  Yes, it’s possible to beat the market but highly improbable on a consistent basis.  I’ve discussed the rationale for my position in prior blogs so I won’t rehash my case, which is largely based on statistical evidence from piles of articles, white papers and books. 

But after digesting a recent study from Vanguard (“The Bumpy Road to Out-performance”, July 2013), I believe they highlight a deeper dimension to this debate that is equally if not more important than the empirical side: the psychological side.  Why is the psychological side so important?  In short, because historical returns from some hot-shot fund can appear to be very attractive but how many of us have the intestinal fortitude or patience to stick with an actively managed (and expensive) fund when it has under-performed the less expensive index for the better part of five years?  My guess is not many, but based on the evidence in this study, that kind of conviction is mandatory in order to benefit from active management.

So let’s look at some numbers in the Vanguard study.  (Aside:  Vanguard is mostly known for index funds so they are “talking their book” as we used to say on the sell-side.  However, the numbers are the numbers so I’m OK with it.  Also, Vanguard does not compensate me one single cent- nobody does except my clients).  Vanguard looked at the 15-year track record of 1,540 actively managed (i.e. “stock picking”) U.S. domestic equity funds and here’s what they found:

Of the 1,540 funds:

  • Only 55% “survived” the 15-year period, meaning they were not merged with other funds or were liquidated (likely due to under-performance)
  • Only 18% of the 1,540 funds (275 funds) “survived” AND outperformed their benchmark
  • The average out-performance (net of fees) was 110 basis points per year
  • Of those 275 funds that actually out-performed, 97% (267 funds) experienced at least five years of under-performance in the 15 year period with 60% of the funds enduring seven or more years of under-performance.  So for 5 to 7 of the 15 years, these funds were losers, relative to their benchmark

Based on these numbers, the question you have to ask yourself is this:  Are you willing to reach for that extra 110 basis points of out-performance with only an 18% chance of being right AND endure what could be seven years of under-performance out of 15 years?  My guess is: No.

Again- we have to remember, we don’t invest “in theory” or in some upper-level Finance class’ “mock portfolio”……we invest in the real world with real dollars and real outcomes affecting peoples’ lives.  This is why I often recommend a sensible and long-term asset-allocation strategy that does not attempt to “hit home runs” trying to beat the market.  As the Vanguard data points out, this “home-run-hitting” is not only rare but also requires almost maniacal allegiance to the chosen fund manager, even with year after year of ulcer-inducing under-performance.

As most of you already know, I believe the best approach for most investors is diversify and to keep costs low.  But in addition to the implementation of the strategy, another important part of my role is to help sustain the strategy.  I find that I may serve as a sounding board for clients’ who suffer from “Cocktail Party Syndrome” where your neighbor, Johnny Know-It-All from up the street brags about his skyrocketing portfolio, which is probably littered with expensive funds sold to him by a broker.  Of course you don’t hear from him when his funds are underperforming. I need to remind clients that long-term and/or retirement funds are too important to be taking a casino approach which is necessary based on the statistics above.

So to wrap up- as we look at the performance of stock-pickers, it is critical to not only analyze the numbers in absolute terms but also the composition of those numbers because as we all know, averages can be very deceiving and usually include volatile swings. This volatility can be stomach-churning and can unnerve investors’ confidence in their “beat the market” fund and contribute greatly to underperformance.  Ask yourself this:  When you pay that premium for something like an 18% chance of out-performing, are you willing to endure years of under-performance needed to collect on that “bet”?

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