I think, if we’re honest with ourselves, most of us think we’re smarter at many things than we are in reality.
It seems pretty easy to pick individual stocks, for instance. You might think you can rely on technical analysis and solid fundamentals, and that picking the next 10 or 100xer can’t be that hard if you truly understand things.
But as most astute investors come to realize, Mr. Market is an amalgamation of everyone, and that can be unpredictable. Fundamentals and technicals are irrelevant. The market is a random walk.
But someone, somewhere, is coming up on the right side. It is a mathematical certainty. Could that be you? Is it worth trying to be?
Jesse Cramer from The Best Interest authored this post exploring this concept.
“You cannot beat the market!”
You hear this warning all the time.
But as we peel back the onion on this advice, we face two logical problems.
- First, there’s an averaging problem. The return of the market is an average. You can’t have everyone losing to an average. The math doesn’t work.
- Second, if my strategy loses to the market, then my anti-strategy should beat the market. Just do the exact opposite of me. Voila. If I lose, you’ll win. Thus, at least one of us has beaten the market.
That was quick. It’s clearly not true to say one can’t beat the market. It’s an incomplete statement. It needs more details, more backup. And it leaves people misinformed. We’re going to fix that today.
Yes, you can beat the market.
But you need to understand how, when, and why.
The question isn’t whether you can beat the market. The question is “why bother trying?”
Myth: “Nobody Can Beat the Market”
This myth is silly. Thousands of people beat the market every day, every month, every year. Some investors have beaten the market for decades.
Anyone who says otherwise is misinformed.
Truth #1: It’s hard…
Consistently beating the market is hard. We’ll cover that more below.
Consistently beating the market after fees is really hard.
If fees aren’t involved, beating the market is possible. Not easy. Certainly not guaranteed. But possible.
But when someone else is managing your money for you, they’ll charge you a fee. That fee eats your profits. And since those profits have been eaten, beating the market becomes harder.
Golf gets harder if you begin your round with a few strokes already on your scorecard. It’s still possible to shoot under par. But harder.
The math of fees and investing and beating the market is that simple.
Truth #2: It’s Not 50/50…
You might think at this point:
Without fees, 50% of stockpickers would beat the market and 50% lose to the market.
That’s a logical conclusion, assuming that stocks’ performances follow a normal distribution, also known as a bell curve.
But equity returns do not follow a normal distribution! This is an interesting and exciting fact.
Instead, they more closely follow a long tail distribution.
Most individual stocks perform worse than average, but a small number of high performers beat the average. As you can see in the image below, there’s a fat cluster of low results. There’s also a “long tail” of high results.
Let’s break down some stats. Huge shout-out to Meb Faber for his research findings.
The following data covers the years 1983-2006, and was published in 2008. The research tracks 8,000 individual stocks over that time (all of which were at one point in the Russell 3000 index). A few intriguing findings:
- 39% of stocks lost money over that 24-year period. Yikes.
- 19% of stocks lost more than 75% of their value. Big yikes!
- 64% of stocks underperformed the index (got beat by the market)
- 36% of stocks outperformed the index (beat the market)
- 18% of stocks outperformed the index by 100% or more
- 6% of stocks outperformed the index by 500% or more
Here’s a graphic visualization of that distribution (again, thanks Meb Faber):
A few other cool stats from the study:
- The mean average annual stock return over this period was -1.06% per year.
- The bottom 75% of stocks had a cumulative total return of 0%. The remaining best 25% of stocks accounted for all of the return in this period.
What Meb Faber’s Research Says About Beating the Market
This research tells us that “beating the market” is not a 50/50 proposition.
Over this researched time period, a single stock had only a 36% chance of beating the market.
There are many bad to mediocre stocks. There are few good to great stocks.
Go have fun with this Google Sheet. I created a fake market of 100 stocks to mimic Faber’s research. You can play around and build a “portfolio” to try to beat the market.
Pick a few stocks? You’re likely to miss out on the big winners and lose to the market.
Pick many stocks? You’ll simply mimic the average return, neither beating nor losing to the market. You’ve created your own index fund.
That is why it’s hard to beat the market.
The Luck vs. Skill Problem
The Google Sheet above is also instructive because your picks are pure luck.
You’re simply picking random numbers. Sometimes your numbers will cause you to win. Most of the time, you’ll lose. This is reminiscent of the parables of monkeys throwing darts.
The real stock market, though, is a mixture of luck and skill. And it’s notoriously difficult to discern between the two.
Skill is repeatable. Luck is not.
If you invest with an active stockpicker you should ask some questions, such as:
- Have they recently beaten the market? If not, why would you invest with them?
- Assuming they have beaten the market, are they skilled? Or just lucky?
- Do you have the knowledge and skill to accurately assess Question 2?
The stock market is a notoriously efficient market. True, repeatable skill is hard to come by.
Note: inefficient markets are different, and can more easily be beaten. Some money managers provide real, repeatable alpha for their investors by proving their skill in inefficient markets.
And any such skill is likely to be found in those who work the hardest.
In other words, the 80-hour weeks of a Wall Street pro are more skilled than the 20 minutes you spend watching Jim Cramer.
Are you sure you want to play that game?
Wouldn’t an average return, like from an index fund, be simpler, easier, and more guaranteed?
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The Truth: Can You Beat the Market?
Saying that nobody can beat the market is like saying that nobody is taller than average. It’s dumb.
But you’ll notice that my tone has changed over this article.
Yes, you can beat the market. It’s a logical necessity. But it’s also complicated.
- It happens less than 50% of the time. That’s what Meb Faber’s individual stock results show us.
- It’s hard to repeat. Sometimes, it’s just luck. That’s what many active management studies have shown us.
- Your investing fees reduce your likelihood of beating the market. That’s basic math.
- Even when you do beat the market, was it skillful? Or just lucky?
- If you’re a DIY active investor, is your time commitment worthwhile?
- Are you smart enough, and unbiased enough, to answer these questions?
These complications all point in the same direction – why bother?
It’s not that you can’t beat the market.
It’s just not worth trying.