Our wealth advisors are often asked if it’s possible for investment professionals to consistently beat the stock market. It’s an understandable question, thanks to the tendency of the financial media to deliver the news that garners the highest ratings.
The truth is that attempts to beat the market are based on incorrect assumptions, also known as hindsight bias, and aren't successful over the long term.
Your Wealth Advisor Knows that Hindsight isn’t Always 20/20
Many active managers and investment professionals fail to appreciate the profound difference between looking forward and looking back, or what economists like to call ex ante and ex post. Investors and active managers with dreams of beating the market tend to believe that the future will be a repetition of the past. They feel like strategies that worked in the past will work just as well, and in the same way, in the future.
Sounds reasonable, right? In the real world, it’s not that simple – in fact, it’s a trap. Thinking that the future will simply be a reproduction of the past is what’s known as “hindsight bias,” and it serves as the Achilles’ heel of many investors and investment professionals alike.
Why? Because the stock market and the economy are infinitely complex systems. Cause and effect are difficult to determine with accuracy. Nothing occurs for a single reason. Stock prices are affected by a number of variables, including but not limited to:
- Interest rates
- The Consumer Price Index (CPI)
- The Gross Domestic Product (GDP)
- Government regulations
- Unemployment rates
- Budget deficits or surpluses
- Corporate earnings
- National and international events
- A company’s financial health
- An industry’s financial health
- The overall state of the economy
- Natural disasters
These are just a few of the countless factors that affect stock prices – and to complicate matters further, these variables are never all positive or all negative. Plus, these variables rarely, if ever, align in the same manner, and they never have the same relative strengths across time periods.
Rational Investors Recognize that the Devil is in the Details
Then there’s the issue of market efficiency, or the belief that stock prices already reflect all available, relevant information. That means that if you detect a recurring pattern of some kind, you might as well just go ahead and assume that it’s already reflected in stock prices – unless, of course, you’re the only person on earth alert enough to notice it.
If you agree that the markets are efficient, then it becomes clear that the force that causes market efficiency is nothing more than the self-cancelation of successful market beating strategies. True, a first-mover may potentially see some gains, but sooner or later the rest of the masses will catch on and those deals will be long gone.
In essence, anyone who wants to beat the market should start from the assumption that “the price is right.” However, active managers always assume that the price is wrong.
Follow Investment Guidance that Takes a Lesson from History
In some cases, valid relationships do exist – but there’s really no way to exploit them. For instance, there’s a strong relationship between interest rates and the stock market: Falling interest rates tend to stimulate the market, while rising rates depress it. Unfortunately, predicting interest rates is about as difficult – and as "effective" -- as predicting the stock market itself. It’s equivalent to predicting bond prices; in other words, something no one ever been able to consistently pull off.
Another example? Oil prices. If you could predict oil prices, you could forecast the probable future prices of oil company stocks. But, again, no one has demonstrated an ability to reliably predict oil prices. In order to predict the future with any accuracy, you really need a working crystal ball, and those are pretty hard to find.
However, this isn’t to say that historical performance is useless. Analyzing the past helps investors see trends over time, such as the ways in which stocks outperform bonds over the long term, or how stocks are more volatile than bonds in times of economic crisis. The past performances of asset classes can be used to prove the benefits of diversification, or to depict consistency of portfolios’ returns vs. selected benchmarks over numerous time periods. But past performance never guarantees future results – or that attempts to beat the market will end in success and no conscientious wealth advisor would ever promise either.