Why you won’t beat the share market (but many still try)

Won't beat the share market

Four things you will learn:

  • Why picking stocks or trying to time the market is pointless
  • Why fund managers have become ‘the market’ (and what that means)
  • How behavioural biases lead us to make bad investment decisions
  • Why index investing is the smart investor’s choice

The US election is the perfect demonstration of the futility of trying to beat the share market.

Those who tried to time their market entry were whipsawed in all directions, share markets initially fell 6% before staging an 8% recovery to close up for the week. Not only did most ‘experts’ call the election result wrong, they completely misjudged the impact that Trump would have on markets.

Meanwhile those with portfolios focused in popular yield-sensitive sectors of the market like property saw their investments crushed due to events in bond markets that were completely outside of their control.

None of this is unusual… time after time, finance commentators have their predictions proved wrong by the market. Those who try and beat the market by timing entry and exit points, or picking stocks or sectors, are outsmarted by each other.

So why is it so difficult for even the experts to get it right?

Stock picking is too popular

Stock picking is difficult for one simple reason:

There are so many people doing it and they’re so damn good at it!

90% of the trading in markets is by professionals and those people make prices very efficient. What does efficient mean? It doesn’t mean the price is always right, but it does mean that nobody knows for sure whether prices are too high or too low right now or where they will be tomorrow.

If most market participants were amateurs it would be much easier for pros to find opportunities. That’s why it worked 40 year ago.

Now people have better and faster access to information online. The funds management industry is a popular well paid job, so information gets reflected very quickly into stock prices because there are so many fund managers. News that everyone knows is already baked into share prices and new news is factored in almost instantaneously. This has been the case at least since the 1990s and why almost all professionals have been beaten by the market since then. There’s no way to consistently predict what’s coming up next.

Even Warren Buffett, celebrated as the most successful active stock picker of all time, says people should not pick stocks anymore. This seems like sensible advice, even his company (Berkshire Hathaway), an active fund, has been beaten by the U.S. share market index (S&P 500) 5 of the 6 last years.

Buffett is tremendously skilled, but being good at picking underpriced ‘value stocks’ isn’t the full story of his success. Buffett has been actively involved in the management of the companies he invests in and is able to create deals nobody else could, like investing in Goldman Sachs preference shares during the financial crisis. Despite his managerial involvement and dealmaking, it’s almost impossible for Buffett to beat the market now.

This is the paradox of professional investing – in the 1960s to 1990s, hedge funds and active fund managers like Buffett made a lot of money. Over the past 40 years, these opportunities have disappeared because of competition.

It’s the beauty of capitalism that if there’s money to be made, the opportunity quickly disappears and this is exactly what’s happened with the funds management industry.

All the shares in the world are held by somebody

The equation is simple – every BHP, Telstra and Facebook share is owned by someone. If you only own a few shares and they’re the good ones that went up by more than the market, then it must be true someone else owns the bad stocks that went up less than the market.

Investing is a zero sum game. All the active managers own all the stocks, so they can only ever deliver the market return before their fees, and less than that after fees. Research consistently shows that about 75% of managers underperform the market each year due to this simple maths. And the 25% that does well is different one year to the next so you can never know who to pick. The shaded green area in this chart shows why only 25% of active managers beat the market on any given year.

Impact of fees on overall returns

That doesn’t mean that some professionals don’t have a good run. Fund managers can often have a great run of success, but performance tends to ‘revert to the mean’ over the long run. A period of good relative performance by a fund manager is often followed by a period of poor relative performance.

Unfortunately because of investor herd chasing behaviour, top performing funds tend to attract lots of money after good performance and before they start to lag. The same happens with ‘hot’ asset classes or sectors of the market – inflows tend to be largest at the top which is exactly when they should be avoided!

Research by Vanguard showed that Morningstar ratings prefer fund managers with good recent performance. As it happened, those fund managers tended to have a period of poor performance after that, which meant that funds with the highest Morningstar ratings did worst over the next 36 months.

Performance after a Morningstar rating
Source: Vanguard

Recent performance is meaningless – focus on fees instead

In 2010, Morningstar conceded that a fund’s fees is a more accurate predictor of future net performance than the Morningstar rating system. In similar research, S&P Dow Jones Indices analysed 715 top-performing funds, focusing on U.S. stock funds between 2010 and 2014. It found only 2 funds stayed in the top 25% through the four-year period.

Fund managers struggle to stay on top for an extended period, as most favour a certain investment style (like value or growth) and these styles tend to come in and out of favour with the market.

The mistake investors make is to put too much emphasis on recent relative performance which is practically meaningless.

The fact is that the lower the fee you pay to the seller of investment services (your broker, adviser or fund manager), the more money there is left for you. Every dollar you pay in commissions, funds management fees, adviser fees or brokerage come directly out of your returns. Fund managers as a group have average performance over the long run, so paying them large fees destroys your long term earning potential. Paying 2.5% in costs each year will mean that 75% of your potential returns are paid to the funds industry over your lifetime!

Performance after a Morningstar rating

75 years ago, Fred Schwed wrote a book called Where Are the Customers’ Yachts? The title came from a story about a visitor in New York. After admiring the yachts that stock brokers and fund managers bought, he wondered where the customers’ yachts were. Of course, there were none.

There is far more money in providing investment services than there is in receiving them.

The DIY option and trading your own money isn’t free either – there are bid-ask spreads, brokerage and tax impacts of trading. Actively buying and selling harms your returns just as much as paying an active fund manager.

So why do people still try to pick stocks?

Hindsight bias tricks people into thinking it’s easier than it is to know when stocks and markets are too high or too low. The people who say “I told you so” quickly forget they had just as many wrong calls as they had right ones. Those calling for a crash are often years or decades too early and miss out on years of good returns in the lead-up. People overestimate their ability to predict the future based on a false belief that they correctly foresaw the past.

Secondly, people still pick stocks because of superiority bias. Everyone thinks they’re better than average. Professional fund managers genuinely believe they can find undervalued stocks better than other professional fund managers. It’s human nature and the same reason why 93% of Americans surveyed by researcher Svenson in 1981 believed they were better than average for driver safety.

Finally, professional fund managers still pick stocks because they get paid extremely well to do so.

Should you still invest when even the experts get it wrong?

The good news is that the more talented people there are working in the market, the more efficient the market becomes and the better off you are accepting market prices by simply investing ETFs that buy every stock in the index.

We’re not surprised that ETFs don’t get much publicity in Australia because they have a big problem – most of the returns go to the investors (you), so they’re not very popular with the traditional investment industry. The wealth management industry doesn’t like them because index funds don’t generate fees for them. This is why we find so many Fat Cat Funds controlled by the big 4 banks and AMP, because many bank advisers get paid for selling you high fee actively managed funds.

How you can win the losers game

Burt Malkiel, the academic who is credited for invested index investing, says to think of investing like tennis – if you’re a professional you win points by doing magical shots. A drop volley here, a backhand overhead there. If you’re a social player you win points by just making less mistakes. If you keep attempting the magical shots as a social player you’re bound to lose due to making inevitable unforced errors.

The 2 most common unforced errors you can avoid to when investing are:

a) Avoid the temptation to pick stocks or pay expensive professionals

The investment industry loves when you buy and sell out of stocks. They want you to pay professional fund managers or advisers because that’s how the thousands of financial planners, brokers and consultants get paid.

Every cent you pay to them comes out of the returns you could have earned for yourself.

That’s why Stockspot only invests in ETFs and we charge low fees because the less you pay us, the more you’ll have leftover in higher after-fee returns. We think any sensible investor with a long term focus shouldn’t do anything but regularly invest in index funds.

We use mainly Vanguard and BlackRock ETFs but if another fund manager had a better lower cost fund, we’d use that one. We don’t have conflicts of interest like many traditional advisers because we don’t get paid from the investments we recommend, meaning we only recommend the best ones available.

b) Avoid the temptation to chase performance

Humans want to chase things that have done well recently. In the world of investing that’s almost always the most dangerous time to invest.

We methodically rebalance our clients’ portfolios to keep risk steady over time and don’t over-trade. When we re-balance portfolios it’s usually out of assets that have done well recently and into those that have done poorly. This is the opposite of chasing performance and hard to do yourself because it feels counterintuitive.

We invest in assets that are less popular and the ones that are popular as returns tend to revert to their long term averages over time. It doesn’t mean the unpopular assets will do well immediately but over the long run assets that do poorly inevitably return to good performance and active investors often miss out.

For example, emerging market returns have been well below developed markets since 2010. Our portfolios contain both emerging and developed market shares because at some point emerging market shares will start performing much better. Emerging market shares also provide an excellent counterbalance to developed market investments because of their inverse relationship with the US dollar.

 

Rather than trying to be Djokovic or Serena, be the social tennis player of investing and win by making less mistakes than everyone else. You can do that by keeping your fees low, investing regularly, not chasing hot markets, and avoiding expensive professionals that try to pick stocks.
 
Credits: Masters of Business podcasts with Barry Riholtz

 

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Chris Brycki

Stockspot Founder and CEO