We often speak with clients who have questions about beating the market; can it be done? Should they be worried if their wealth advisor doesn't try? Why doesn’t our investment firm include beating the market on our list of viable wealth management strategies?
Despite what you see on TV and read online, overwhelming evidence shows that over any significant period of time - trying to beat the market doesn’t work.
Here’s why it’s not effective
– and why so many investment professionals insist on trying anyway.
Is Your Investment Professional Enamored by a Thrilling Lie?
Perhaps Dr. Daniel Kahneman, Nobel Prize winner and Princeton professor, said it best:
“The idea that any individual without extr
a information or extra market power can beat the market is extraordinarily unlikely. Yet the market is full of people who think they can do it and full of other people who believe them. This is one of the great mysteries of finance. Why do people believe they can do the impossible? And why do other people believe them?”
And perhaps the best answer to his query lies in a quote by Aldous Huxley, "An unexciting truth may be eclipsed by a thrilling lie.”
A thrilling lie is one way to describe the way the financial media -- and Wall Street itself -- promotes beating the market as a viable investment technique. After all, it's much more exciting to hear about the rare success story than steady gains over time. But investment guidance based on this strategy just doesn't pay off the way the media and Wall Street would have you think. So why do so many investment professionals continue to follow this path?
Despite consensus amongst researchers and wealth advisors (and years of empirical evidence from the markets themselves), most investment professionals and active managers continue their quest to gain abnormal returns from beating the market. If only they believed in market efficiency, or the idea that the market already reflects all current and available information, they could spend their time and money more productively. As Kahneman said, it’s a great mystery… or is it?
Don't Be Blinded by Appearances
Some investors do appear to beat the market, and therein lies the reason why some investment professionals doubt market efficiency.
So have these apparent market winners somehow discovered a magical way to identify mis-priced securities? Casual observers think so; they might also believe that active managers and investors possess superior research abilities or special intuition.
In reality, producing above-average returns isn’t the result of having a winning strategy for beating the market. Rather, it’s just luck.
But when you hear about a money manager generating excess returns, the tendency is to assume it was the result of skill, not luck. In fact, it’s easy to assume that above-average results in any endeavor are due to skill – or a combination of luck and skill. You might even think that it’s impossible to determine whether luck or skill had more influence – but you’d be wrong.
Skill vs. Luck: Which Does Your Investment Firm Offer?
One way to determine the cause of results is by charting overall results. If results fall into the pattern known as a bell-shaped curve, you can reasonably assume that it was just raw chance at work. At the very least, a bell-shaped “normal distribution” provides evidence of randomness; and as it happens, a bell-shaped distribution is what we observe when we examine how well active management really works.
Nobel Prize winning economist Eugene Fama looked at active managers’ results over a lifetime of investing and found that, after accounting for fees, only 3% actually demonstrated skill at generating excess returns. In other words, what you’d expect if only chance was at work.
If anything, this distribution of results actually indicates that active managers are unlucky.
If you were in a casino and you noticed someone raking in the dough at roulette, you’d assume their winnings were due to luck, right? So why is it that when people hear about a money manager generating excess returns, the tendency is to assume their success is due to skill and intelligence? The consensus of research and statistical analysis is that luck plays exactly the same role in creating excess returns as it does in winning at the roulette wheel.