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Individual Investors vs. The Market

I frequently make the case that individual investors have little hope of reliably outperforming the market by trying to pick investments on their own. A recent comment on a post from a couple months ago argued that individual investors do have some advantages that might help them reliably outperform the market.

The commenter pointed out that:

  1. Mutual funds are required to stay within a given asset allocation range. Individual investors, on the other hand, can move entirely to cash or entirely to stocks whenever they see it as beneficial.
  2. While each individual trade is a zero sum game in terms of who will come out ahead, some investors aren’t necessarily seeking to come out ahead. That is, “Zero sum games can be beat if everyone is playing for different reasons.” For example, elderly investors might buy dividend stocks simply because that’s what they’re comfortable owning.

Individual Investors vs. Mutual Funds

Regarding the first point, that’s true. Fund managers are not allowed to move entirely into cash whenever they see fit. (Thank goodness!) People have been bringing this up for years. (They usually also point out that fund managers can’t invest more than 5% of the fund’s assets in a given stock, whereas individual investors have the ability to do so.)

Admittedly, these are at least potential advantages to individual investors. The problem is that to be able to exploit these advantages, investors have to be able to:

  • Predict short-term market movements (such that moving into or out of cash would be beneficial), and/or
  • Pick stocks that are likely to outperform the market (such that putting a large portion of one’s portfolio into a given stock would be beneficial).

Every piece of data I’ve seen on the topic indicates that individual investors have little hope of being able to perform either of these feats reliably. And that makes sense; most of us just don’t have the resources.

Individual Investors vs….Other Individual Investors

As to the second point above–the one about zero sum games–again, this one makes sense on a (wonderfully fascinating) theoretical level, but it seems difficult to exploit to one’s advantage.

Even if we assume that there are investors who buy stocks without the intention/hope of beating the market, what percentage of stocks do these investors own? I suspect it’s rather small.

And, more to the point, I’d be willing to bet that these older investors have far lower portfolio turnover than most other market players, meaning that the likelihood of one of these investors being on the other side of any given trade is exceptionally low.

Am I missing something?

What do you think? Is there something I’m leaving out that gives individual investors a meaningful advantage over other market players?

When to Sell an Actively Managed Mutual Fund

A friend recently sent me an email asking for my advice regarding a one of his mutual fund holdings.

The fund underperformed the market pretty seriously over the last year. As a result, it now has 3-year and 5-year performance records that are below those of either an S&P 500 index fund or a Wilshire 5000 index fund–despite the fact that the fund was a big outperformer in prior years.

His question was how to know whether the fund manager had “lost his touch.”

My answer, of course, was that there’s no way to know. And in fact, it’s impossible to say for sure whether the fund manager ever had a “touch” to begin with.

His question highlights what I see as one of the biggest issues with holding actively managed funds:

  • If the fund has outperformed the market over the period that you’ve owned it, how do you know whether the fund manager has genuine skill or just good luck?
  • If the fund has underperformed, is it because the fund manager “lost his touch?”* Or is he still a skillful manager–one who has simply had a bad year? Or, was the fund manager never skillful to begin with?

In either case, you’re stuck asking yourself, “should I continue holding this fund?”

Index Funds & Peace of Mind

By way of comparison, with an index fund, you never have to rely on the existence of a brilliant fund manager. All you’re betting on is the likelihood that the businesses of the world, over time, earn a net profit.

(Side note: That’s just one of the reasons why I sleep better at night knowing that I’m invested in index funds.)

What about you?

For those of you who invest in actively-managed funds, how do you decide when to throw in the towel and find a new fund?

*In terms of the possibility of a fund manager “losing his touch,” I doubt that any truly skilled professional would spontaneously lose his skill. However, if his above-average performance was the result of exploiting a particular market inefficiency, it’s possible that that inefficiency could eventually be eliminated, causing the fund’s above-average performance to end.

How to Get Rich with Stock Market Newsletters

Write one.

Then sell subscriptions.

Ta-da! 😀

Troubleshooting (in case you need a little more help)

What’s that? You don’t have a history of successful stock picking? No problem: Just come up with any stock-selection strategy and back-test it to see if it’s worked over the past [period of your choosing].

It didn’t work? Again, no problem: Just continue back-testing assorted strategies until you find one with an absurdly high performance record. Once you do, heavily promote that past performance, while only mentioning in a small footnote that you didn’t actually own any of the investments mentioned over the period in question. [Update: The prior sentence used to be a link of an almost-hidden disclosure on the Motley Fool website, which has since been removed completely.] Apparently, nobody will notice.

Won’t people figure out that it’s a scam once they see that your strategy isn’t working going forward? Yes, they will. But don’t worry; it will probably take a few years. In the meantime, just start a new newsletter with a new back-tested-for-success strategy.

Or–if you don’t like my method–Carl from Behavior Gap has an alternative (and perhaps better) way to manufacture an excellent past performance record.

Now get out there and go make your fortunes! 🙂

Don’t be a (Motley) Fool.

Update: I stand by my assessment of the Motley Fool (that investors as a group would be better off without it and the rest of the stock newsletter industry). But I couldn’t have been more wrong about the contributions Brokamp would make to Get Rich Slowly. His articles have provided sound, helpful advice. Two examples:

Get Rich Slowly (the single largest personal finance blog, I believe) recently began hosting a regular column from a Motley Fool writer.

Score one for the bad guys.

But everybody loves the guys from The Motley Fool, right?

Spare me.

A few headlines to be found on Fool.com as I write this (5/7/09):

  • “5 Cold Stocks Heating Up”
  • “5 Stocks with a Bright Future”
  • “These Are the Market’s 10 Best Stocks”

Ugh. If those headlines aren’t a perfect example of a “get rich quick” philosophy, I don’t know what is.

They promote their newsletters’ performance with large green lettering: “Outperform by 40.05%.” To me, that sounds suspiciously like they’re indicating that you will outperform by that amount if you buy their newsletter. Am I the only one to whom this looks like a misleading use of past performance figures?

What The Fools do:

As far as I can tell, The Motley Fool’s entire business is built upon convincing people that it’s easy to beat the market.

Never mind the fact that only a handful of investors have ever done it for a sufficiently-extended period to give us any sort of confidence that it was due to anything other than luck.

Never mind the fact that every single trade is a negative-sum game due to transaction costs.

Never mind the fact that, in total, investors’ quest to beat the market is impossible by definition.

Never mind the fact that if we stopped paying newsletter publishers, stock selection services, active fund managers, and all the other charlatans who encourage us to engage in this fruitless endeavor, we’d be better off by $100 billion every year.

My complaint

My issue is not with the particular stock picks that they promote. My complaint is with their promotion of the idea that stock picking is a prudent form of investment.

To think that individual investors (Yes, that means you.) have any meaningful advantage over the institutional investors–i.e., the people with whom we’re trading when we buy or sell stocks–is nonsense.

If we could remove our emotions for a minute, it should be obvious that it’s rare for individual investors to know anything that the institutional investors don’t. We have less time to monitor our investments. Less access to research. Less analytical resources to use.

Both common sense and an enormous body of research tell us that our best bet is simply to stop trying and invest instead in low-cost, passively managed funds. If anybody tells you that it’s easy to beat the market by picking stocks, they’re probably either

  1. poorly informed, or
  2. about to sell you something.

Spend a couple minutes on the Fools’ website, and I think we can see which group they fall into.

The fools on index funds

Yes, I’m aware that they also promote index funds. But they do it in the most half-hearted, two-faced way possible. For every article on their site promoting index funds, there’s another article right next to it indicating that any investor with an ounce of intelligence can beat the market.

What do you think?

Am I wrong? Is it reasonable to listen to The Motley Fool? Or am I right that trying to beat the market is a fool’s errand?

Please let me know what you think in the comments.

To be clear, Robert Brokamp’s articles appear to be far more reasonable and well informed than much of the rest of the Motley Fool site. My complaint is not with him specifically, but with the principles espoused by Motley Fool in general.

Skill vs. Luck in Mutual Fund Performance

Let’s imagine a hypothetical group of 1,024 actively-managed funds. If we look at pre-expense results, roughly 50% of the funds should outperform the market each year. That means that after 7 years,

  • 8 of the funds will have outperformed the market every year,
  • 64 funds will have outperformed the market in at least 6/7 years, and
  • 232 funds will have outperformed the market in at least 5/7 years.

And that’s based purely on luck. No need for any fund management skill at all.

According to the Investment Company Institute, at the beginning of 2002, there were 4,756 equity mutual funds. Using our numbers from above, we can see that pure luck would account for 1,077 different funds outperforming the market in at least 5 of the last 7 years on a pre-expense basis. There would even be 37 funds that would have outperformed in each of the last 7 years.

And yet, I suspect that most of us are inclined to think “wow, this guy is good!” when we see a fund with a record of beating the market for each of the last 7 years. Oops.

The simple fact that a fund manager has outperformed the relevant benchmark index doesn’t tell us very much at all.

What about extended periods of outperformance?

According to Jeremy Siegel (in Stocks for the Long Run), in order to be able to say with 95% confidence that a fund manager’s performance is due to skill rather than luck, he’d need to outperform the market by an average of 4% per year for roughly 15 years. (If the fund was only outperforming by 3% annually, it would take more than 20 years.)

The problem, however, is that by the time we’ve seen a fund manager outperform the market for 15 years in a row, it’s not particularly likely that he (or she) will be managing the fund for much longer.

So how should we choose funds then?

Of course, picking an actively-managed fund with a long-term record of outperformance is probably better than picking an actively-managed fund with a long-term record of underperformance. But don’t fall into the trap of assuming that a fund manager must be a genious simply because he’s beaten the market for the last several years.

Rather than focusing exclusively on past performance when choosing mutual funds, try doing the following:

Investing in Actively-Managed Funds

  1. Outperforming the market by picking stocks and/or market timing is rather difficult.
  2. Less than 50% of actively-managed funds will beat a low-cost index fund.

So it seems to me that investing in an actively-managed fund is the rough equivalent of saying, “I don’t have an above-average ability to pick stocks, but surely I can do an above-average job at picking an actively-managed fund!”

Many investors–myself included for a few years–don’t seem to pick up on the fact that selecting an actively-managed fund must not be as easy as it looks–i.e., simply choosing a fund with great past performance.

If it were that easy, then everybody (including other fund managers) would already be doing it. And if that were to happen, then by definition the original outperforming fund could no longer be an above-average performer.

Takeaway: Just like with picking individual stocks, beating the market by picking actively-managed funds requires that you either:

  1. Get lucky, or
  2. Know something that the market doesn’t.

And I assure you, a fund’s past performance is never unknown to the rest of the market.

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