Why Smart People Fail to Beat the Market

The reason why these guys won't beat the market is because mentally, they think they can't do it. They find all ways to convince themselves that it is impossible to beat the market, including quoting Issac Newton.

Even in the face of evidence, they try their best to massage data based on risk adjustment.

On the other hand, authors like those of the "Little Book of Beating the Market" grossly portray a real life unrepeatable 20% outperformance of the market.

What a world this place is....



Rick Ferri, Contributor

 I cover low-cost index fund and ETF investing.
ETFs |  3/12/2012 @ 8:51AM |9,309 views
Why Smart People Fail to Beat the Market


There are only two ways to beat the stock market in the long-term, net of expenses: one, trade on superior information; two, be lucky. I tend to believe that getting lucky has a much higher probability of working than finding superior information.

Finding superior information is very difficult. It either requires access that other people don’t have, or the ability to analyze public data better than the vast majority of investors. It’s widely known that most mutual fund managers underperform the market, even with the deep and talented pool of analysts they have access too. Once in a while they’ll get it right, but it’s not often enough to make up their cost.

Princeton professor and Nobel Laureate Daniel Kahneman helps explain why people think they’ll guess right more often than wrong in his new book, Thinking, Fast and Slow.  The human brain is incapable of creating new information − it doesn’t know what it doesn’t know. To compensate for the unknown, our brains attempt to piece together the best possible story based on what we do know. Sometimes this story is accurate and sometimes not. When we’re right, we think it’s because we’re smart, and when we’re wrong, we think it’s because we didn’t have enough information and there was nothing we could do about it.

Author and money manager Larry Swedroe summarizes why we have a strong desire to believe we’re right all the time in his recent Journal of Indexes article, On Magical Thinking and Investing. He cites excellent behavioral finance sources to explain why investors keep trying to out-guess the markets when the deck is so clearly stacked against them. Swedroe labels the need or desire to be an above-average investor as the “Lake Wobegon effect,” named for the popular radio series set in the mythical town of Lake Wobegon, where all the men are strong, the women are good-looking and the children are above-average.

My argument isn’t to make the claim that the market cannot be beaten with analysis. I would never say that. It’s easy to find mutual fund managers who have beaten the market in the past. It’s much harder to determine if a particular manager was lucky or skillful at doing it.

Eugene F. Fama and Kenneth R. French looked into this issue in their working paper titled, Luck versus Skill in the Cross Section of Mutual Fund Returns. Their study focused on U.S. equity mutual fund managers from 1984 to 2006. It’s no surprise that they found that in aggregate, actively-managed U.S. equity mutual funds performed close to the market before costs and below the market after costs. The big question they were trying answer was did the winning managers have skill or were they just lucky?

To answer this question, Fama and French compared the distribution of fund returns to a distribution of simulated portfolio returns formed with randomly selected stocks. Using a bootstrapping technique, they created thousands of simulated U.S. equity portfolios that selected stocks randomly. The range of actual mutual fund returns was then compared to the range of bootstrapped returns. The overlay was very close, which means most actual fund returns were a result of random stock selection and not skill.

There were, however, a handful of funds whose managers outperformed the bootstrapping method after adjusting for costs and risks. These so-called outliers may possess skill, if only they could be identified. Unfortunately, knowing that a manager had skill ex post doesn’t help investors much, because we need to place our bets ex ante, and it’s not possible to determine which managers will possess skill in the future. We only know that some will.

What if we forget about mutual funds and choose a few good stocks ourselves? We often hear that individual investors have an advantage over large institutional investors because we’re able to act more quickly than the institutions and buy stocks that are too small for them to bother with. Do these apparent advantages increase the odds that we can beat the market with a well-crafted portfolio of individual stocks?

Years ago, I enjoyed following the Wall Street Journal’s “Dartboard” contest. This challenge was inspired by Burton Malkiel’s book, A Random Walk Down Wall Street. The Princeton Professor wrote in his book that “a blindfolded monkey throwing darts at a newspaper’s financial pages could select a portfolio that would do just as well as one carefully selected by experts.”

Here is how the contest worked. The journal’s editors would periodically ask four leading Wall Street investment analysts to submit their single best stock pick. These four picks were matched to four stocks randomly selected by throwing darts at the stock pages of the paper. The eight picks were then printed in the Dartboard column for all to see. Six months later the results were printed.

 More than 100 contests took place over the years. They were followed closely by both efficient market believers and non-believers. When the darts won, efficient market people cheered and pointed to the utter uselessness of trying to beat the market. When the pros won, the non-believers hailed the Wall Street analysts. Their skill was proof that stock picking reins superior.

Truth be told, neither method outperformed the market. The raw data did point to the experts as the overall victory, but this was before adjusting for risk. In addition, just the announcement of a new set of picks caused those stocks to jump on the very first day they were traded. People wanted to believe that the experts were expert. The darts had no such guru status and the stocks they landed on had no jump in price.

Enter an academic to provide impartiality to the Dartboard results. Professor Bing Liang of Case Western Reserve University published a paper in the January 1999 edition of Journal of Business titled “Price Pressure: Evidence from the ‘Dartboard’ Column.” He discounted the jump in the experts’ stock picks on the first day because this return wasn’t possible to earn unless an investor had inside information before the WSJ published the picks. He also adjusted the stock picks for the higher risk the experts were taking. Liang’s conclusion was that, “On average, investors following the experts’ recommendations lost 3.8% on a risk‐adjusted basis over a 6‐month holding period.”

There has been, and always will be, a minority set of investors who beat the market. The question is whether their good fortune is a result of luck or skill? The academic data suggests that most outperformance is a result of good luck.

Greek shipping tycoon Aristotle Onassis once observed that, “The secret of success in business is knowing something no one else knows.” Like Onassis, we know there are people in the world that have access to superior information and will make money because of it. We just don’t know who they are, and it may not matter even if we did. Onassis wouldn’t have managed my money even if I did know him.

I don’t have access to superior information. I read the same journals, papers, blogs, and research as everyone else. My advantage is that I know what I don’t know, and unlike most investment advisors, I don’t have to make believe I know more. My portfolio is diversified among low-cost index funds that track the markets.

If you know what I know, or less, then your portfolio should be managed in index funds also. Don’t feel bad about being an index fund investor. Being honest about our skill, or lack of it, releases us from an expensive denial. Index investing is a more profitable investment solution than what the masses of investors who remain in denial will achieve in their lifetimes.

By the way, we’re in good company. Some of the most brilliant minds ever to have walked the face of the Earth have come to the same conclusion. After losing a fortune investing in South Sea Bubble stocks during the early 1700s, Sir Isaac Newton famously confessed, “I can calculate the motions of heavenly bodies, but not the madness of people.” Now, that’s one really smart guy. He would have liked index funds.