Investment Belief #1: Investing Successfully is Really Hard
Investing successfully is really hard. Investors are necessarily exposed to so much uncertainty, so much randomness and so many variables that it simply isn’t reasonable to expect to succeed routinely. In fact, it’s surprisingly easy based upon the available data to wonder if it’s reasonable to expect to succeed at all.
To put things into perspective a bit (based upon some research by David Yanofsky for Quartz and beginning at the start of 2013), if you had picked the best stock to buy every day and put all of your money in it at the beginning of the day before selling it at the end of the day, you could have turned $1,000 into $264 billion by mid-December alone. Therefore, if you didn’t achieve a 100 percent return for 2013 you didn’t get even 4/10-millionths of what was available for the taking. In other words, nobody is getting remotely close to what the market offers. None of us is all that good.
It’s easy to dismiss the Yanofsky research as silly, of course. Nobody expects to pick every winner even if the research offers a helpful reminder of just how sub-optimal our investing inevitably is.
Yet investment performance still fails in the aggregate even when more reasonable benchmarks are used. While it’s easy enough to falsify the Efficient Markets Hypothesis, it is still maddeningly difficult to beat the market, no matter how smart and diligent you are. A few simple examples – far more than should be needed to make the point – follow.
- As I have noted before, in 2006, the TradingMarkets/Playboy 2006 Stock Picking Contest – involving Playmates and professionals alike – was won by Playboy’s Miss May of 1998 and a higher percentage of participating Playmates bested the S&P 500′s 2006 returns than active money managers. Thus over the course of a full year, a bunch of Playmates outperformed a whopping majority of highly trained and experienced professionals with vast resources who spend all day every day trying to beat the market.
- As Charley Ellis has pointed out, “research on the performance of institutional portfolios shows that after risk adjustment, 24% of funds fall significantly short of their chosen market benchmark and have negative alpha, 75% of funds roughly match the market and have zero alpha, and well under 1% achieve superior results after costs — a number not statistically significantly different from zero.”
- Morgan Housel recently discovered that the companies with the most Wall Street sell ratings in January of 2013 outperformed the market for the year by a median 25 percentage points while those with the most buy ratings underperformed by more than seven percentage points.
- The S&P Dow Jones Indices most recent year-end report confirms once again that actively managed funds — where managers try to beat the market by making good investment choices — tend to underperform their benchmarks. Similarly, the S&P Dow Jones Indices latest persistence report shows yet again that even those few funds that come out on top can’t consistently (persistently) stay there.
- The latest Dalbar QAIB data shows that over the past 20 years, the average equity investor has suffered an aggregate underperformance of nearly 50 percent while the average fixed income investor has suffered an aggregate underperformance of nearly 85 percent.
- Hedge funds, the least regulated and most highly compensated area within the finance sector, seem to have performed worst of all. In his book, The Hedge Fund Mirage, Simon Lack showed that the hedge fund industry as a whole lost more money in 2008 than it had made in all of the previous 10 years. Even worse, “if all the money that’s ever been invested in hedge funds had been put in Treasury bills instead, the results would have been twice as good,” especially since nearly all the hedge funds’ gains went to managers rather than clients.
Not only is it really hard to succeed at investing, it’s getting harder all the time. As Michael Mauboussin explains in his excellent book, The Success Equation, as overall skill improves, aggregate performance improves and skill becomes less important to individual outcomes. Indeed, good research suggests that our industry has become ever more sophisticated and complex over the past three decades or so but to little effect. In other words, the ever-increasing aggregate skill (supplemented by massive computing power) of the investment world has come largely to cancel itself out.
Perhaps worse, when you actually do make a smart investing move (purchasing an investment that will outperform, however you define that), its impact is reduced every time somebody else follows suit. It is axiomatic in the investment world that as an asset class becomes more popular, it suffers from both falling expected returns and rising correlations. Good trades get crowded and their advantages tend to disappear.
While lots of really smart people are using essentially all their time and vast resources trying to get ahead in the markets, a vanishingly small number of people are actually succeeding. Being really smart and diligent has demonstrated surprisingly limited upside overall. The appropriate conclusion is unmistakable. Investing successfully is really, really hard.
This post is the second in a series on Investment Beliefs. Such stated beliefs can suggest a framework for decision-making amidst uncertainty. More specifically, one’s beliefs can provide a basis for strategic investment management, inform priorities, and be used to ensure an alignment of interests among all relevant stakeholders.
I think it depends what your definition of successfully is. If you define successfully as beating the market or beating all other investors then yes it can be difficult. However, if you define success as earning a good return and growing your wealth over time, investing successfully is actually quite easy. Just buy solid blue chip companies and hold for the long term.
I don’t think the answer is anything like as clear-cut as you do. First off, why do you assume that past performance is indicative of future results? Your approach is much like the “Nifty Fifty” craze of the 1960s — it worked well for a while and then didn’t for another while. Later in this series (#3, I think) I will be discussing the wisdom of holding all of one’s investment beliefs tentatively and provisionally. Moreover, the “long-term” isn’t always available (due to age, personal situation or what the money is targeted for). Finally, our behavioral and cognitive biases conspire against our doing what you suggest — almost nobody does it. If it were really as easy as you say, more people would be doing it.
I agree with Dan Mac here, I have a portfolio that leans towards a dividend growth investing style and have seen my portfolio best the market for many years now. I like doing my homework and finding great businesses and admit that it may be difficult for some, but can easily be taught if one want to learn. I keep my portfolio tight and currently own less than 20 individual stocks of high quality and tend to have a real long-term bias.
That may be so, Joe, but the research evidence that people lie (or are badly mistaken) about their personal investment performance is remarkable. A very large percentage of people who claim to be successful really aren’t when the numbers are well and truly crunched. Moreover, “many years now” isn’t usually statistically significant. Nifty Fifty investors (very similar to the approach you espouse) were successful for a lot of years. And then they weren’t anymore (beginning in 1972 or so) for another noteworthy string of years. Again, if it were so easy, lots more people would be doing it successfully.
Bob, I completely understand what you are saying, but I would have never have invested in the “Nifty Fifty” blindly without doing research and that is where those investors went wrong, I have bought and continue to hold such companies as GWW, MA, DIS, SBUX, UNP, just to name a few…and some of these holding go back to the Tech bubble….I have had some losers (if you want to call them losers) such as PEP, MSFT, INTC, CSCO, but my overall portfolio substantially out-performed literally any index…just because I batted .600 and the market batted .250. I never say that it is easy, but there is absolutely nothing wrong with hard work that pays off. Thanks again for the reply.
From Charley Ellis in the Financial Analysts Journal:
“New research on the performance of institutional portfolios shows that after risk adjustment, 24% of funds fall significantly short of their chosen market benchmark and have negative alpha, 75% of funds roughly match the market and have zero alpha, and well under 1% achieve superior results after costs — a number not statistically significantly different from zero.”
Assuming you have achieved the level of performance you claim, there are two logical possibilities. Either (a) you’re in with Warren Buffet and Seth Klarman as part of the miniscule number of truly fabulous investors; or (b) you were very lucky. Obviously, (a) is possible, and that’s what we’d all like to think if we had seen that level of returns, surely. But the research is crystal clear that (b) is far, far more likely.
Bob, unlike Buffet…my holdings are few (less than 20) and when the market corrected in 2000/2001 and in 2008/2009 I put more funds into these names (maybe like Buffet) realizing when their is value, I was not perfect on the timing, but both times have rewarded me. I, do however agree with you that most mutual funds cannot beat the indexes and even Buffet himself has trouble (too many holdings and maybe not enough growth names), but history is on my side: when you hold quality companies with growing earnings, growing sales, brand power and re-invest dividends and think long-term (decades) you will do fine (and avoid those pesky fees). We may disagree on this, but continued succes.
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Bob, I greatly enjoyed your intro article to this series, and this one is a good first post. I’m looking forward to the rest! The data and research that you point to is…well…it is what it is. Nobody can reasonably argue that most mutual funds have outperformed, etc. However, and I anticipate that you will consider some of these caveats in future articles, many/most of these studies are specific to large pools of money. When you bring it down the individual investor level, however, the entire landscape shifts fairly dramatically.
I’m assuming you have seen this, but in case not, look at Rob Arnott’s presentation in the following link, particularly slides 4-11. https://www.nomura.com/events/global-quantitative-equity-conference/resources/upload/2013/rob-arnott.pdf
Essentially every rules-based systematic non-market cap weighted strategy has outperformed the cap-weighted index for 50 years. Even Malkiel’s monkeys outperform the index in 98% of cases. So, liquidity, trading costs, and staying away from behavioral errors are the keys to actualizing that performance in real time. A $500,000 portfolio is dividend-growth oriented stocks has an infinitely higher chance of outperforming, relative to a $2 billion portfolio, all else equal (and all else is often equal when it comes to “skill” or lack thereof of portfolio managers).
Since Joe isn’t a big institutional fund, he isn’t in the 1% of people who substantially outperform an index. I have zero doubt that people of modest skill can outperform an index based on controlling their emotions, staying disciplined, and paying attention to factors such as trading costs, so long as their portfolio isn’t in the tens of millions of dollars.
I’ll be getting to these issues in future posts. I agree with some of Rob’s points, but you might also take a look at James Montier’s counterpoint summarized here:
For what it’s worth, I like “smart beta” a lot more than risk parity, but the devil’s in the details — more to come on that. I’ll have more to say about Joe’s approach later too.
Bob, I read Montier’s piece when it was first published. No question that he is a brilliant writer, but there’s also no question he has an ideological ax to grind which, amazingly enough, matched up with his employer’s ideological ax. 🙂 Not to say that I completely disagree with him, but there is a strong marketing element in what he writes. I happen to agree with him largely about risk parity, although there is much to like in Sharpe’s tangency portfolio…but being completely price indifferent a la classic risk parity is certainly not efficient.
Smart beta offers a lot of potential. Will be interested in your viewpoints.
We know what works in investing – make sure your portfolio matches your purpose, diversify broadly across large/small and growth/value stocks globally (ideally with a tilt to small/value), dampen portfolio volatility with high-quality bonds, keep costs low, minimize taxes, and avoid making unnecessary changes/tweaks.
Yet successful investing isn’t easy. Because, as the saying goes – we’ve seen the enemy, and he’s staring at you in the mirror.
Excellent advice that’s very simple (yet anything but easy). Thanks for reading and commenting.
Nice discussion going on here, I know that to some stocks are treated as trading vehicles, but I tend to treat them for what they are…investments, long-term. Bob, just so we are clear my portfolio also holds some mutual funds such as Vanguard Small Cap index in my personal account and several funds from Vanguard in my 401K: PrimeCap, Total Bond and the S&P 500. Overall my Dividend-Growth Roth IRA has performed extremely better than my 401K…My holding are as followed: PEP, BK, MA, SBUX, TROW, GWW, UNP, NKE, COST, DIS, PKG, LAD, and PSA…and non dividend payers SAM, UA, CMG, CTSH, FLT and ODFL. All long-term and mostly quality…lol. Special note, I have been investing in stocks since the 87 crash and have learned from my mistakes and have simply focused on serious quality since the Tech bubble. Hope this info helps.
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I am like Joe who commented up here. A liar or plain old lucky? No I think that my past success in stock markets can be explained. I have worked as Investment Analyst, trying to estimate Target Prices for companies assigned to me. I was not very successful at this. I think most people who work in Finance are overwhelmed with the data, metrics and methodologies. I now trade from home rarely holding more than 10 companies over more than one year. I do basic analysis that anyone can do, including playmates. Study the markets and practise.
My advice for big gains is invest in small (micro) cap. It is impossible to predict if Microsoft or McDonalds, Google or Apple will perform up to expectation over the years…it is a wild guess, shit happens. The opportunities are in short term Micro cap. Choose very carefully and timing is key. It is not hard to separate the ‘holly shit that company has an amazing product if it works out and makes it to market i will be rich’ (80% don’t) from the ‘This company offers a tested product/service ready for market with high demand, has some competitive advantage and with strong management yet is undervalued’. The latter is a good buy however the former has more hype and venture capitalist jump on that romance. While it may be hard to believe that good, low risk/high gain, micro-cap companies exists, after sifting thousands of companies I find a dozen per year…worth the efforts and well rewarded… ha! What a liar!
I think that the reason people in finance are not successful are given in a post of yours. This explains 100 % of why 95% of people suck!
Good investing – like good decision-making generally – requires patience, a willingness to go-against-the-grain and an independent mindset. You’ll never get ahead of the pack by doing what everybody else does. Much about our business and our make-up seems to demand instant results and instant evaluation. In this instance at least, the trend is not your friend.
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