Anyone who has ever tried to beat the market for a long period of time has probably made a grimace when reading the above title. They will know from experience what a daunting task it is. Research shows that only about 1% of active traders outperform the most popular reference index, the.
Warren Buffett had a million dollar bet in 2007 that a Vanguard S&P 500 index fund would outperform a basket of hedge funds over a ten-year period.
S & P 500 versus hedge fund returns since 2011
Buffett easily won that bet because the S&P 500 annually returned a net of 7.1%, compared to just a net 2.2% for the hedge funds. This raises the question, why is the market so fast?
The efficient market hypothesis
This investment theory, called & # 39; EMH & # 39 ;, claims that if the market displays all currently known information, consistently beating the market is impossible. According to this principle, there are no undervalued or overvalued assets; everything is exactly as it should be priced. As a result, there is no room or opportunity to generate additional income.
Yet some have consistently identified lucrative investment opportunities, so perhaps the reality is that while the market is to some extent efficient, it is not flawless. In general, market prices are right, but it makes a strange mistake here and there. And it is these errors that may open the door for alpha generation.
However, this is not where the difficulty ends.
Even if there is an edge …
To beat the market, you have to act differently from other market participants. In the past, a way to do this was missing out on a piece of useful information noticed by the rest. But this was in the days before information was freely distributed and at a time when products such as the Bloomberg Terminal did not exist.
Today, financial market competition is more difficult than ever on two fronts: first, most professional investors have access to the same data in real time and can use algorithms for immediate action, and second, Wall Street is home to some from the smartest financial minds, and since every transaction needs a seller and a buyer, it is too easy to outwit everyone.
Do not exceed many shares
Another reason that outperforms the market is so challenging that not many stocks outperform the broader market. Research at Arizona State University in 2017 found that four out of seven common shares have a & # 39; buy and hold & # 39; return of less than one month of treasury paper.
The study also showed that since 1926, the best-performing 4% of listed companies generate net profit for the entire stock market. For 2018, for example, it would have been Advanced Micro Devices (NASDAQ :), Netflix (NASDAQ :), and Amazon (NASDAQ :), rising by 103%, 62%, and 49%, respectively, while the wider S & P 500 returned – 6.5%.
Building a separate portfolio increases the likelihood that an investor will miss out on one of the 4% stocks that could drive his return high enough to outperform the market in a given year. JB Heaton explains in "Why Indexing Works" how, in a world with five shares, if 4 shares return 10% and one share returns 50%, the overall market performance is 18% – but any portfolio without the only good shares would underperform the.
Emotion
The fact that the market makes it difficult to perform better is not the only reason why most people fail to do this. After all, we are only human and people often act in a suboptimal way, responding to emotional triggers. Indeed, the effects of fear and greed have been extensively documented
The preview theory, put forward by the Nobel Prize winners Kahenman and Tversky, shows that losing $ 100 has a stronger negative psychological effect than winning $ 100 has a positive psychological impact. People are risk-averse and this tendency causes us to make the wrong risk / return choices, which inevitably has a negative effect on our return. In the same way, people who are blinded by a potential reward will ignore the risk factor and make themselves vulnerable to negative consequences in the longer term.
Costs and taxes
And that's not all. To paraphrase Benjamin Franklin in financial markets, nothing can be said with certainty except fees and taxes. Buffett & # 39; s famous bet was on net return, after mandatory deductions. Buffett opted for a tax-efficient ETF, but higher capital gains from hedge funds and active traders on higher sales naturally lead to more substantial tax benefits.
The same revenue creates fees, and crucial is that fees are another important reason that many investors do not beat the market. A certain percentage of your trading capital goes to fees, which you then have to compensate in the return to match the performance of the market. The more you trade, the more fees you pay, and therefore the higher the return you have to make – and we have established above that generating alpha is not a simple task.
Conclusion
Is it unnecessary to beat the market with all these extra layers that are difficult to overcome for investors? Investors such as Warren Buffet and Peter Lynch – a strong proponent of buy-and-hold investing – have both made their fortunes through stock selection and beating the market over a long period, proving that it is possible. But it has never been easy and now more than ever it requires a powerful combination of skills, happiness, balanced psychology and smart accounting. Unfortunately for most of us, this winning combination can be frustratingly elusive in our imperfect human world.
