CHAPEL HILL, N.C. – Beating the market is so hard that if you give up you would have to apologize.
But contrary to what happens when you give up elsewhere in life, in the investment space it's actually a smart strategy to win.
After more than 40 years of rigorous review of investment advisor performance, I've learned that buying and holding an index fund that tracks the S&P 500 is long term
or some other broad index is almost always ahead of any other attempt to do better, such as B. Market timing or the selection of specific stocks, ETFs and mutual funds.
It's amazing, when you think about it, what other occupation is there in life that you can win almost every race by just sitting on your hands and doing nothing?
I am not saying that it is impossible to beat the market. What I am saying is that it is very difficult and rare. And it is even more rare that an advisor who beats the market in one period does so in the following period as well.
I'm not the first to point this out. But what I can add to the debate is my extensive performance database, which dates back real returns to 1980. It convincingly shows how incredibly slim your chances of winning are when trying to beat the market.
My first step in drawing investment lessons from my huge database was to compile a list of investment newsletter portfolios that were in the top 10% of performance at some point since 1980 in a given calendar year. Given the many newsletters my Hulbert Financial Digest has been watching over the years, this list of top decile performers with more than 1,500 portfolios has been sizeable. Due to their design, the percentiles of their performance rank all fell between 90 and 100 and averaged 95.
What I wanted to measure was the performance of these newsletter portfolios in the year immediately following. If performance were a matter of ability, we would expect them to have been in the top decile of performance for this second year too – with an average percentile rank of 95 as well.
However, I did not find that – nowhere near. The average percentile rank of these newsletters was only 51.5 in the second year. This is statistically similar to the 50.0 it would have been had the performance been hit and miss.
Next, I repeated this analysis for each of the other nine deciles for first year achievement rank. As you can see from this graph, their expected ranks were very close to the 50th percentile in subsequent years, regardless of their performance in the first year.
The only exception was for newsletters in the bottom 10% for first year returns. The average percentile rank in the second year was 38.8 – well below what one would expect if performance were pure luck. In other words, it's a good bet that the worst advisor in one year will also underperform the following year.
What these results mean: While the performance of investment advice is not a matter of pure chance, the deviations from chance occur primarily with the worst performers – not the best. Unfortunately, that doesn't help us beat the market.
By the way, don't think you can wriggle your way out of these conclusions by arguing that other types of consultants are better than newsletter editors. At least in terms of persistence (or lack of it) between past and future performance, newsletter editors are no different from managers of mutual funds, ETFs, hedge funds, and private equity funds.
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Beware of arrogance
While I believe the data is conclusive, I am not holding my breath that it will convince many of you to throw in the towel and opt for an index fund. That's because all too often the typical investor believes that the bad odds of beating the market apply to everyone else, but not to them individually.
It reminds me of the famous study in which almost all of us state that we are above average drivers.
Obviously, this arrogance has dangerous consequences on our roads and highways. But it is also dangerous in the investment sector because it leads investors to take ever greater risks.
This creates a downward spiral: if the arrogant investor begins to lose to the market, which sooner or later inevitably happens, he is pursuing an even riskier strategy to compensate for his previous loss. This in turn inevitably leads to even greater losses. And the cycle repeats itself.
The temptation to arrogance is particularly evident on social media. Psychologists have found that younger investors are much more likely to pursue risky strategies when being watched than when acting alone. This helps explain the courage so often shown on investment-oriented social media platforms.
Buying and holding an index fund is boring. Followers are rarely drawn to social media, and even when they are, they rarely post that they are continuing to hold the same investments they have had in years.
Beware of this trick too
A similar dynamic leads to those who visit social media bragging about their spectacular winners while ignoring their losers. They often do this by projecting their returns from a short-term trade for the year and then boasting about that number. Imagine a stock that goes from $ 10 to $ 11 in a week. In itself, that doesn't seem particularly remarkable. However, on an annualized basis, this equates to a profit of more than 14,000%.
Readers of this social media practice must first believe that they are the only ones with a mix of profit and loss deals. It was only later that they discovered the unspoken rules of social media platforms: It is a bad way to ask fellow investors about their losers, just as it is bad etiquette after a round of golf to ask the boastful golfer if he actually hits par .
Modesty is an investment virtue. We do well to adhere to Socrates & # 39; famous line to remember: "I am the wisest man in the world, because one thing I know, and that is that I know nothing."
Mark Hulbert is a regular contributor to MarketWatch. His Hulbert ratings track investment newsletters that pay a flat fee for testing. He can be reached at email@example.com.