There’s this idea out there, perpetuated by financial professionals and online “experts” alike, that if you take the right approach, do the right research, and put in the right amount of effort, you can pick stocks that beat the market.
There are, of course, the people who are pretty obviously scam artists, promising crazy returns if you just follow their “system.”
But there are a lot of other people who sound a lot more rational. People who talk about things like dividend investing and value investing. People who talk about taking a defensive approach or who emphasize their expertise in a particular industry.
Many of these people explain their ideas in simple terms that make sense, and they occasionally seem to have the data to back up their claims.
Their pitch is appealing. They make it sound like it’s pretty simple to beat the market if you have the right information and the right discipline.
Unfortunately, most of it is garbage. And I have the data to prove it.
Even the Experts Can’t Beat the Market
Every six months, S&P Dow Jones Indices produces something called the SPIVA US scorecard. This report compares the performance of actively managed mutual funds to their benchmarks over various time periods to see just how effective professional investment management actually is.
There’s a lot of information in this scorecard, but here’s the main headline: Whether you look at the past 3, 5, 10, or 15 years, only about 15% of all professional mutual fund managers were able beat the market.
That’s less than 1 in 6 professional investors. These are people who are trained, paid, and spend their careers looking for best investment opportunities.
And given that index investing allows people to invest directly in those benchmarks they’re being compared to, the only way they can justify their jobs (and the fees they’re charging) is to outperform.
And fewer than 1 in 6 can do it.
On top of that, their average underperformance over the past 15 years was 1.1%. That is, they lost to the market by 1.1% per year for 15 years.
That may not sound like much, but it would have cost you $13,342 if you were investing $5,500 per year (the current IRA contribution limit) for that entire 15-year period, assuming 7% market returns. If you continued to receive that same underperformance for another 15 years, you’d end up losing a total of $103,452 compared to the market.
And remember, these are people who devote their lives to this. They’re smart, well-trained, they work hard — and the vast majority of them still underperform the market by a wide margin.
If that’s the case for the professionals, it’s unlikely that you or the person pitching you their stock-picking strategy will be any different.
The Best of the Best?
The logical counterpoint to the data above is that there is still that one professional investor out of every six who is able to beat the market. If you can find that person and either invest with them or mimic their strategy, you’ll be able to beat the market too.
Unfortunately, there’s another report that lays that argument to waste as well.
S&P Dow Jones Indices also produces The Persistence Scorecard, which tracks whether the mutual funds that beat the market over one time period continue to beat the market over subsequent time periods.
After all, if there’s genuine skill involved then we should see the same professionals and the same mutual funds outperform time and time again.
The truth is that we see pretty much the exact opposite.
This most recent report looked at all the mutual funds that finished in the top quartile (top 25%) for returns in one year and tracked how they performed over subsequent years. It found that just 1.94% of those funds were able to maintain that top-quartile performance over three years, and a measly 0.34% we able to keep it up over five years.
Those percentages are less than what you’d expect from pure chance, and the results are the same even if you look at longer periods of performance to try and account for random year-to-year variation.
When these same mutual funds are evaluated over two consecutive five-year periods of performance, only 39.86% of the mutual funds that outperformed over the first five years continued to outperform over the second five years.
Again, random chance would expect 50% of them to continue their outperformance, so these professional investors are less consistent than a coin flip. In fact, the report concludes that “the data show a stronger likelihood for the best-performing funds to become the worst-performing funds than vice versa.”
All of which is simply to say that there is no consistency to the performance of these professional investors. The vast majority of those who are outperforming are doing so out of pure luck and are more likely to significantly underperform the market going forward than they are to continue beating it.
What Does All of This Mean for You?
It’s not impossible to beat the market. In fact, all of the data above show that a tiny percentage of professional investors are able to do it with at least some degree of consistency.
It is possible for you to find one of those professionals and invest with him or her, or to be one of those investors yourself.
But it’s incredibly unlikely.
What the data really say is this:
- Almost all of the people who try to beat the market fail to do so.
- They typically fail by a significant margin.
- Even if you’re lucky enough to beat the market over one period, you will almost certainly fail to do it again.
In other words, stop trying to beat the market!!! It’s basically an impossible goal, and it’s especially unnecessary when index investing exists as an easy and readily available alternative that research has shown time and time again to produce better results.
The experts can’t beat the market and you don’t need to try. Your future self will thank you if you don’t.
Matt Becker, CFP® is a fee-only financial planner and the founder of Mom and Dad Money, where he helps new parents take control of their money so they can take care of their families. His free book, The New Family Financial Road Map, guides parents through the all most important financial decisions that come with starting a family.