Element 4.9: Realize No One Can Consistently “Beat the Market”

“A blindfolded monkey throwing darts at a newspaper can select a portfolio that can do just as well as one carefully selected by experts.”

Many people refrain from investing in stocks because they feel they have neither the time nor the expertise to identify businesses that are likely to be successful in the future. They are correct about the difficulties involved in forecasting the future direction of either an individual stock or a broad measure of its average price. No one can say for sure what will happen to either the price of any specific stock or the general level of stock prices in the future.

Most economists accept the random walk theory. According to this theory, current stock prices reflect the best information that is known about the future state of corporate earnings, the health of the economy, and other factors that influence stock prices. Therefore, future changes in stock prices will be driven by surprise occurrences that people do not currently anticipate. By their very nature, these factors are unpredictable. If they were predictable, they would already be reflected in current stock prices.

Why not pick just the stocks that are doing well like Apple, Google, and Microsoft, and stay away from everything else? That is a great idea, except for one problem: the random-walk theory also applies to the prices of specific stocks. The prices of stocks with attractive future profit potential will already reflect these prospects. The future price of a specific stock will be driven by unforeseeable changes and additional information about the prospects of the firm that will only become known over time. Countless factors affect the future price of a particular stock, and they are constantly changing in unpredictable ways. The price of Apple stock could be driven down, for example, as the result of an idea a high-school kid is working on in his basement right now. Thus, there is no way that you can know ahead of time which stocks are going to rocket into the financial stratosphere and which ones are going to fizzle on the launchpad or crash after takeoff.

It is unlikely that you can even improve your chances a little by studying the stock market, the details of particular corporations, and economic trends and forecasts. Some of you will do better than the market, just by chance, while others will do worse. Meanwhile, many of you will spend a great deal of time and energy that could have been put to better use trying to game the market. The key is that while someone will always beat the market, researchers have no ability to predict in advance who that will be.

But what about all those ads you see on the Internet saying something like “Gorilla Investments has beaten the market for TEN years in a row!!! Send us your money NOW, before it’s too late!” Are they lying to you? Well, not quite. Try a thought experiment. Start with 10,000 friends and have each of them flip a fair coin (50% chance of landing heads and 50% tails). Half will call it right. Then do it again but only with the 5,000 who “won” the first time. At the end of ten tosses 20 of your friends will have called it right 10 times in a row. Those are the ones who will take out ads offering their coin-flipping services. Investment advisers work the same way.

For most of us, the best option will be to channel our long-term (that is, our retirement) savings into an equity mutual fund. Exchange traded funds (ETFs) are similar to mutual funds but are traded on actual stock exchanges.

There are two broad categories of equity mutual funds: managed funds and indexed funds. A managed equity mutual fund is one in which an “expert,” the fund’s portfolio manager, decides what stocks will be held and when they will be bought and sold. The fund manager is almost always supported by a research staff that examines both individual companies and market trends to identify those stocks most likely to do well in the future. The manager seeks to pick the stockholdings of the fund in a manner that will maximize the fund’s rate of return.

The second type of fund, an indexed equity mutual fund, merely holds stocks in the same proportion as their representation in broad indexes of the stock market. Little trading is necessary to maintain a portfolio of stocks that mirrors a broad index. It is also unnecessary for index funds to undertake research evaluating the future prospects of companies. Because of these two factors, the operating costs of index funds are substantially lower, usually by 1 or 2 percentage points, than those of managed funds. As a result, index funds charge lower fees, and therefore a larger share of your investment flows directly into the purchase of stock.

An equity mutual fund indexed to a broad stock market indicator, such as the S&P 500, will earn approximately the average stock market return for its shareholders. The United States is not alone in having index funds. Most large economies have one or more such funds and more are being opened regularly. It is possible to purchase index funds for individual developing countries including some in Eastern Europe (iShares MSCI China ETF, Franklin India Index Fund, Expat Czech PX UCITS ETF or VanEck Vectors Russia ETF). You can also buy regional funds that track shares in a particular set of countries.⁽¹⁴⁵⁾

What is so great about the average return? As noted earlier, historically the stock market has yielded an average real rate of return of about 7 percent. That means that the real value of your stockholdings doubles approximately every ten years. That is not bad. Even more important, the average rate of return yielded by a broad index fund beats the return of almost all managed mutual funds when comparisons are made over periods of time, such as a decade. This is not surprising, because, as the random walk theory indicates, not even the experts will be able to forecast consistently the future direction of stock prices with any degree of accuracy. Some will just like some sets of coin flips above turned up heads ten times in a row, but economic research suggests this is due to either luck or something illegal.

Over the typical ten-year period, the S&P 500 has yielded a higher return than 85 percent of the actively managed funds. Studies of European active vs. passive managers support these findings.⁽¹⁴⁶⁾ Over twenty-year periods, mutual funds indexed to the S&P 500 have generally outperformed about 98 percent of the actively managed funds.⁽¹⁴⁷⁾ Thus, the odds are extremely low, about 1 to 50, that you or anyone else will be able to select an actively managed fund that will do better than the market average over the long run.

Just like your friends’ flipping coins, just because a managed mutual fund does well for a few years or even a decade, it does not follow that it will do well in the future. For example, the top twenty managed US equity funds during the 1980s outperformed the S&P 500 Index by 3.9 percentage points per year over the decade. But if investors entering the market in 1990 thought they would beat the market by choosing the “hot” funds of the 1980s, they would have been disappointed. The top twenty funds of the 1980s underperformed the S&P 500 Index by 1.2 percentage points per year during the 1990s. Similarly, the average return of the top twenty US managed equity funds from 1990 to 1999 outperformed the S&P 500 Index by 3.1 percentage points per year, but from 2000 to 2009 those same funds underperformed the S&P 500 Index by 1.3 percentage points per year.⁽¹⁴⁸⁾ For the twenty-five-year period 1993–2017, the S&P 500 Index yielded an annual rate of return of 9.7% compared to an annual return of 8.6% for the average managed equity fund.⁽¹⁴⁹⁾

These examples actually understate the advantage of a mutual fund indexed to the S&P 500 compared to a managed equity fund because of the survivorship bias. The S&P 500 index is highly unlikely to go out of business, but over the period relevant to saving for retirement, a managed fund is quite likely to shut down. A mutual fund can disappear for two reasons, both related to poor performance: It may be shut down with the remaining value of the fund distributed to its owners or it may be merged into another managed fund with a better record. Although there are thousands of managed mutual funds today, in 1970 there were only 358 in the United States. Burton Malkiel followed those funds through 2013. During these forty-three years, 274 funds—over 75 percent of the total—ceased to exist. Out of the remaining 84, only four had outperformed the S&P 500 index by 2 percentage points or more on an annual basis.⁽¹⁵⁰⁾

The stock market has historically yielded higher returns than other major investment categories, and index funds make it possible for the ordinary investor to earn these returns without worrying about trying to pick either individual stocks or a specific mutual fund. A study that compared 118 years of returns on stocks and bonds from 21 countries with data going back that far showed that stock market returns outperformed bond returns over the period for every country.⁽¹⁵¹⁾ They even returned an average of 3–6% annually, despite including the periods of the two World Wars.

Of course, there will be ups and downs and even some lengthy periods of declining stock prices. Therefore, many investors will want to reduce equities as a percentage of their asset holdings as they approach retirement (see Element 4–10). But, based on a lengthy history of stock market performance, the long-term yield derived from a broad index of the stock market can be expected to exceed that of any other alternative, including managed equity funds.⁽¹⁵²⁾

Source: Linqun Liu, Andrew J. Rettenmaier, and Zijun Wang, Social Security and Market Risk (National Center for Policy Analysis Working Paper No. 244, July 2001). The returns are based on the assumption that an individual invests a fixed amount for each year in the investment period. Data are updated through 2019.

As Exhibit 29 illustrates, when held over a lengthy period, a diverse holding of stocks has historically yielded both a high and relatively stable rate of return. Data for the highest and lowest average annual real rate of return derived from broad stock market investments for periods of varying length between the years 1871 and 2019 are shown here. The exhibit assumes that the investor paid a fixed amount annually into a mutual fund that mirrored the S&P 500 Index.⁽¹⁵³⁾ Huge swings are possible when stocks are held for only a short time. During the 1871–2019 period, the single-year returns of the S&P 500 ranged from 47.2 percent to −35.5 percent. Even over a five-year period, the compound annual returns ranged from 29.8 percent to −16.7 percent.

However, note how the “best returns” and “worst returns” converge as the length of the investment period increases. When a 35-year period is considered, the compound annual return for the best 35 years between 1871 and 2019 was 9.5 percent, compared to 2.7 percent for the worst 35 years. Thus, the annual real return of stocks during the worst-case scenario was about the same as the real return for bonds. This high and relatively stable long-term return makes stocks a particularly desirable method of investing for retirement.

Here is the most important takeaway from this element: Do not let lack of time and expertise keep you out of equity investments. You do not have to do a lot of research or be a “super stock picker” to be a successful investor. Regular contributions into an indexed equity mutual fund will provide you with attractive returns on long-term investments with minimal risk. For most people, these investments will be an important ingredient of a sound retirement plan. Every large reputable investment firm will have several indexed equity mutual funds from which to choose. Each firm may have a slightly different name for their fund, so be sure to read the description to determine the one that best fits your needs.

The second most important takeaway from this element is that economists enjoy poking fun at market “analysts.” Among the reported stock pickers that have outperformed “professionals” are a Russian circus chimpanzee who outperformed 94% of Russian mutual funds and a cinnamon ring-tailed monkey named Adam Monk who picked his stocks for the Chicago Sun-Times by circling his choices with an orange pen. The Observer, a British newspaper, organized a challenge in 2013 between three teams. One was a group of novice finance students, the second was comprised of a wealth manager, a stockbroker and a fund manager, while the third team was…a ginger tabby cat named Orlando. By the year’s end, the students lost money, the pros gained 3.5 percent, while Orlando (who would toss his toy mouse on a grid of choices) showed a return of nearly 11 percent. As one commentator observed, “The great thing about letting a cat pick your stocks for you is the low fees.” Had they been actual investments, Orlando would have provided an excellent return for kibble and catnip.