Investing Successfully is Really Hard

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.

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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.