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May 22, 2020

Why Trying to Beat the Market is Always a Losing Game

When an investor is in the news for ‘making it big in the stock market’ they’ll often credit being in the right place at the right time, giving the impression that they somehow knew what stocks to pick to double (or triple) their investment. 

This myth is harmful to investors who are just beginning and are afraid of picking the wrong stock or not timing the stock market. After all, with the hundreds of thousands of companies trading on the stock market, how can you figure out which ones are going to give outstanding returns?

The truth is, you can’t.

Think about switching car lanes during rush hour. Doesn’t it always seem like the lane next to you is moving faster than the one you’re in? And yet, if you end up switching, you most likely don’t get to work or home any faster. Trying to time the market works the same way – there’s always going to be talks of a recession or boom right around the corner. Renowned investor Warren Buffet said at one point that “the years ahead will occasionally deliver major market declines — even panics — that will affect virtually all stocks. No one can tell you when these traumas will occur.” But on the flip side, he also said that “those who invest only when commentators are upbeat end up paying a heavy price for meaningless reassurance.”

Clearly, trying to beat the market is a losing game for a few different reasons.

For one, it’s proven practically impossible to beat the market. Investors who try believe that markets aren’t efficient – that stocks are mispriced and can be bought or sold to make a profit. Making a profit from mispricing in the market is often a goal of active managers. Active management seeks to produce better returns than those of passively managed index funds. For example, a large cap stock fund manager attempts to beat the performance of the Standard & Poor’s 500 index.

However, this chart from cnbc.com shows the percentage of large cap active funds that did not beat the S&P 500 in 2019:

These findings aren’t uncommon. Historically, a high percentage of active managers do not manage to beat market returns, which means most people are better off just investing in an exchange-traded fund (ETF). ETFs are funds that track a stock market index (for example the S&P 500). ETFs are listed on most major stock exchanges and investors can buy or sell shares of ETFs just like corporate stocks.

But surely, some managers do manage to beat the market, right? Otherwise, why would there be a market for active managers? Some managers and investors do outperform the market during a specific time period.

However, no one can beat the market consistently.

Here’s the percentage of active managers who did not beat their benchmarks over the long term:

A report published by S&P DJI shows that “over long-term horizons, 80 percent or more of active managers across all categories underperformed their respective benchmarks.” So an active manager can beat the market by notable percentage points, but lose heavily the very next year. Also, since past performance of a manager does not guarantee future returns, investing in stocks that have previously done very well may not translate into outstanding returns in the future.

Even for managers who can back up the claims that they outperformed the market, be careful of survivorship bias. Managers usually end up liquidating funds that aren’t performing as well as the market, so the surviving funds give the appearance that all of the managers funds are doing better than they actually did.

“The disappearance of funds remains meaningful,” the report notes. “Over 15 years, 57 percent of domestic equity funds and 52 percent of all fixed income funds were merged or liquidated.” 

Say you trust a manager to get you above average returns and do it consistently, the fees may negate any superior returns. As an illustration, look at this chart by Vanguard showing how a 2% fee can eat away at your investment returns over 25 years.

Thanks to the magic of compounding returns, the fees you pay for any management and expenses adds up to an astronomical amount over time. Most times, the extra percentage points in fees you might pay for a manager to actively manage your investments cancel out any active returns. The fees look like a small percentage (for example 1.4%) but that 1.4% can end up being tens of thousands of dollars over your investing lifetime. 

Finally, you might not have enough resources to DIY your way through beating the market.

In the New York Stock Exchange (NYSE), institutional and high-speed machine trading account for 98% of total trading. With all the resources at their disposal, institutional investors can root out any market anomalies within microseconds. The average individual investor simply cannot match the time and effort needed to beat the market, even if above average returns were conclusively guaranteed.

When it comes to beating the market, think of the adage “if you can’t beat ‘em, join em.” The best way to win the game is to invest in low fees, passive funds consistently over a long period of time. By focusing on diversifying your portfolio and staying steady during periods of market volatility, you can achieve financial success and turn your investment portfolio into a reliable source of returns for your future self.

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