How Easy is it to Beat the Market?

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Last updated on March 7, 2007 Comments: 7

On one hand, we have brokers, or salespeople, who sell financial products designed to put the most money in the hands of the people who manage and sell said products. On the other hand, we have financial advisors who swear that for long-term investing, index funds will provide the best and safest return. The brokers say their products beat the “average” returns provided by index funds that follow the market while index fund proponents say most managed funds won’t consistently beat the market’s return.

So who is right? Tim Middleton from MSN Money has an opinion about the issue. We’ve been tricked to believe index funds represent the market.

If you’ve been tricked into thinking an S&P 500 index fund is a one-stop solution to your portfolio planning, it’s understandable. Thanks to relentless promotion from Standard & Poor’s and Vanguard, the 500, in the minds of investors, “represents the market…” If your life’s goal is a gentleman’s C, indexing was invented for you. But if you think you’re as smart as Lisa Simpson, who gets A’s, you’ll find it takes very little homework to earn them.

Middleton’s article compares performance (to a maximum of the last 5 years) between index funds and above average and “really good” mutual funds. Later on in the article, the author says something very interesting.

It is true that over long periods, popular indexes and group averages converge. That’s not surprising: Most fund managers’ pay is linked directly to a benchmark. If their clients include pension funds and insurance companies, which value conventional investment wisdom above everything, they can be fired for doing too well.

Mutual fund managers purposefully seek lower returns to keep their jobs safe? That is a strange concept to me. Middleton provides some names of managers who have consistently beaten their related index funds over the long term. But using the author’s own logic, how can you invest with managers who have beaten the average? Middleton admits that superior performance will eventually return to the average. In order to converge, funds returning superior performance would have to provide lackluster performance while the “average” fund continues providing average returns.

By the time you determine who the star managers are, it’s likely too late to invest with them. Eventually, their performance will converge with the index funds.

Can you pick star managers before the rest of the world? That’s the only way you can easily make a lot of money with managed mutual funds. In order to pick star managers, you’re going to need information that the rest of the investing world doesn’t have, according to the efficient market hypothesis.

Can you spot a Warren Buffett, Bill Miller, Bill Gross, or Bob Rodriguez before everyone else can?

Think of it this way. Most likely, you missed out on Microsoft‘s total return of 2,784% from March 28, 1986 to March 20, 1992 (six years). More likely, you’ve seen something similar to a total return of 1,004% from March 20, 1992 to March 6, 2007 (fifteen years). Google lets me compare MSFT with the S&P index over the last six years and in this period of time, the index returned above 10% while MSFT returned less than -10%.

Buying Microsoft after its first periods of superior returns is like buying a manager who has already seen his or her best years. All that’s left is to return to the average.

Article comments

Anonymous says:

You sound like you’re either advocating buying the individual stocks that comprise the index or you don’t believe in long term investing. If the former, you’re going to get killed on transaction costs. If the latter, I’ll agree that there are no guarantees but note that there has never been a 15-year period in the market that didn’t make money.

Where is it written that we have to BEAT the market anyway? On average, half of us will and half of us won’t; That’s what “the market” is, not some arbitrary number chosen by bluesuits. All you really have to do is beat inflation with a large enough stockpile to retire at the age you’ve chosen in the lifestyle you’ve chosen. Now, if your goal is more specific, such as turning $100 into $5M by age 40, I hope you have a backup plan.

Anonymous says:

Nagel: for a large-cap index, you’ll pay under 20 bps. I’d take a bet that my S&P 500 index fund will outperform a comparable large-cap blend or growth fund. Even in the Journal of Financial Planning, the CFP-types in there acknowledge there are only a couple spots that active management CONSISTENTLY outperforms passive management. I can’t recall the 3 (out of ~12) areas, but I think it was something internationally, small cap growth, and maybe midcap value.

The idea of core/satellite investing seems to make a lot of sense. Take a good S&P or total market index fund that you’ll hold onto forever and build off of that. You’ll probably choose some other areas to index with a little bit (i.e. less than half) of active management.

Luke Landes says:

Nagel: While nothing is “guaranteed” there is more of a chance that the index will rise over the long term than any one company (or ten companies) that even the most astute pick.

You can do all the homework you want, but most likely, whatever information you find will all ready be priced into the stock.

Anonymous says:

I personally do not believe it is prudent to invest in a large cap index or mutual fund. If you do your homework and learn the companies you can do this on your own. There is no guarantee that the index will rise over a long-time horizon and who want to pay 100 basis points for a manager that tracks the S&P 500 when you are paying him to demolish it.

Anonymous says:

> If their clients include pension funds and insurance companies, which value conventional investment wisdom above everything, they can be fired for doing too well

I think what he meant to say is that if they deviate from the index _and_do_worse_ they can be fired but if they simply match the index, they will be fine, so there is no incentive to take the risk of going against the herd.

Certainly managers can and do beat the market, but its difficult to tell the difference between the lucky managers who won’t be able to do it consistently, from the smart managers who will. You have to wait until they have a long term track record and then everyone knows they are good and their funds are so large that it now becomes difficult for them to continue that trend. Their success becomes a drag on their future performance.

Anonymous says:

If a hundred people flip a coin a hundred times, there will be a few people who consistently flip “heads”. They will have beaten the odds by luck. The same thing is true of fund managers. When there are thousands of funds, there will be a few fund managers who consistently beat the market. The trick is to separate the skillful fund managers from the merely lucky ones.

Anonymous says:

The Key argument against this guy’s position is his own statement that “It is true that over long periods, popular indexes and group averages converge.”

He appears to be advocating that the best way to beat the market is to pick the best managers and the best funds. The precise reason that I would argue that index funds are a smart choice is that the repercussions of picking the wrong manager are soooo much worse than picking an index fund.

Sure, if you pick the right fund, you can beat the market. The problem occurs when you pick the wrong fund. And in the long-term you can wear yourself out jumping from winning fund to winning fund (and assuming you can keep your streak going), but in the end, as the author admits, “It is true that over long periods, popular indexes and group averages converge.”