Beating the Market

Most investors have the expectation that they can beat the market or that they can pay a professional manager to do it for them. After all, there is something very natural about believing you can do better than average.

The human desire to ďbeat the marketĒ is a powerful force and investors spend a considerable amount of time, effort, and money trying. An investorís belief that they can outperform the market is reinforced by a multi-billion dollar investment industry and the army of sales people it employs to sell their products.

The really smart investors know that the net results of trying to beat the market are not worth the time, effort, and money spent. Unfortunately most investors never learn this. A quick review of the data will make it apparent that beating the market over long periods of time is just not realistic.

This does not mean that an investor/manager can not beat the market. In fact, a handful of investors/managers do every year. It is just impossible to identify which managers will fall into that category each year in advance. And history shows it is not worth the risk to try.

Donít just take our word for it. Letís take a look at the data. The graph below shows the percentage of actively managed stock funds that failed to beat their appropriate index over the last 5 years.

As you can see, about 70% of actively managed stock funds failed to beat their appropriate index. Had the International Small category been compared more appropriately to an index that included emerging markets, the underperformance would have been over 70%.

Bond fund managers fared even worse than stock fund managers. The graph below shows the percentage of actively managed bond funds that failed to beat their appropriate index over the last 5 years.

As you can see, over 80% of actively managed bonds funds failed to beat their appropriate index.

If that were all the data, you could still make a decent case for active management. All youíd have to do is consistently pick managers in the top 25% or so. In fact, thatís the argument many advisors make to lure you in.

Next letís take a look at the consistency of the managers who were able to beat their appropriate index in a single year. The graph below shows the percentage of actively managed stock funds that were able to continue to beat their appropriate index over the last 5 years.

As you can see, less than 1% of managers who were able to beat their appropriate index in year one were able to consistently do so over the five year period. THIS IS LESS THAN YOU WOULD EXPECT BY CHANCE ALONE.

Again, bond fund managers fared even worse. The graph below shows the percentage of actively managed bond funds that were able to continue to beat their appropriate index over the last 5 years.

As you can see, less than .3% of managers who were able to beat their appropriate index in year one were able to consistently do so over the five year period. AGAIN, THIS IS LESS THAN YOU WOULD EXPECT BY CHANCE ALONE.

In fact, the number of successful active managers is even worse than the data indicates. This is because of what is known as survivorship bias. Survivorship bias exists because each year a number of actively managed funds close and disappear Ė most due to underperformance. The disappearance of these underperforming funds makes the total sample of funds smaller which makes the successful managers appear to be more abundant.

Letís take a look at the number of actively managed funds that disappeared over the last 5 years. The graph below shows the percentage of actively managed stock funds that disappeared over the last five years.

As you can see, over 30% of all actively managed stock funds vanished after 5 years.

Bond funds didnít fare much better. The graph below shows the percentage of actively managed bond funds that disappeared over the last five years.

As you can see, over 28% of all actively managed bond funds vanished after 5 years.

As the above data shows, it is unlikely that you will beat the market in any given year. Over time, the odds of you beating the market only diminish. To prove this, letís look at an example:

We saw from the data above that an investor has about a 75% chance of underperforming the market in any given year which means you have a 25% chance of beating the market in any given year. To calculate your odds of beating the market over any particular period of time, you would just multiply your odds of beating the market in each year in the sample.

For example, to calculate the odds of beating the market over a 2 year period, you would multiply 25% times 25% to get 6.25%. As your time period increases, your odds decrease. See table below:

Number of years

Odds of beating the market

1

25%

2

6.25%

5

0.098%

10

0.00000095%

20

0.00000000000090%

30

Letís just call it zero

To summarize, we are not saying it is impossible to beat the market, but we are saying the odds are stacked so far against you it makes little sense to try Ė especially with any amount of money you know you are going to need.

At PIG, we donít ďroll the diceĒ with your money. We donít try to beat the market with arrogance, some arcane black-box, or a made up voodoo formula. We construct globally diversified portfolios with a tilt toward the factors that have yielded return premiums over time.