Why the average investor can never beat the market, but why some investors still might
One of the biggest arguments in investing is whether an investor can beat the market. There’s the issue of market efficiency, which in effect says that the market as a whole (and by the way, a market is made up of its participants) know more than you, and therefore, prices already reflect fundamental value. But we don’t need to get into this particular, highly academic issue for the purpose of this discussion.
Instead, we’re going to take a quick look at the math of markets, and the “active” versus “passive” question. This discussion is inspired in particular by a fairly famous article by an even more famous (in academic finance) thinker: “The Arithmetic of Active Management” by William F. Sharpe (originally published in The Financial Analysts’ Journal, vol. 47, no. 1, January/February 1991. pp. 7-9, and available here).
A passive investor is one who buys an index, either by directly replicating it (which no one does on their own), or through an index fund (extremely common). They accept the overall return of this index. An active investor, for the purposes of this discussion, is any investor who deviates from an index that they use for comparison. We would argue that even if you only hold two stocks (which we think is a stupid idea), as long as you tell your friends “I lost/made money versus the S&P 500,” you’re an active investor. Professional active managers often explicitly benchmark against an index: their entire portfolio is designed to beat one specific index.
One of the key points that Sharpe makes is that the average active return (before costs!) must be the same as the passive return. Take a look at this graph:
The market tends to go up over time. This is because businesses produce profits, buy assets, retain earnings (dividends reduce the market cap of a company, and market cap is what most indexes, and therefore charts of market performance, are based on, but dividends equal less than total earnings), and over time their value increases, on average. But individual stock buy and sell transactions are necessarily a zero-sum game: if you sell $AAPL to me for $100, I pay you $100 – $100 changes hands at that moment. One of us gains, the other loses. In the graph you can see that the average of buy and sell decisions. Imagine each dot as an investor. The market goes up, but some people sell when they should have held, or vice-versa. So the average of all active decisions nets to 0% beyond what the market produces on its own. If the market returns 7% on average, even if one investor made 8%, someone else only made 6%. So the average of all active investors’ returns equals the passive return.
Bottom line: before fees, the average investor’s return is equal to the market return.
After fees, the average investor’s return is less than the market return. Fees include all of fund management fees, trading commissions, etc. So minimizing fees is important. Paying the lowest cost you can to invest puts you one step ahead of everyone else.
So the question is, can you be a green dot consistently? You’re competing with all of Wall Street, and Bay Street, and both the City of London and Canary Wharf (London’s dual financial hearts), and so on, all around the world. There are tens of thousands of professional investors running portfolios. How likely are you to be able to consistently beat them? We’re all kinda small fish in a big sea. This begins to tie back into the market efficiency question: can you have information that provides a consistent edge? Versus those big guys, it seems unlikely, and many would argue they don’t have an edge either.
Our personal opinion at Stocktrades is that there is too much emphasis placed on “beating the market.” At the end of the day, this isn’t actually a competition. The market return is pretty darn good. For us, it makes more sense to own the market portfolio, minimize fees, and choose an asset allocation that’s appropriate for your desired level of risk and personal circumstances.
Would you rather hit it out of the park once in a while but strike out most of the time, or consistently get to first base?