Steve Forbes, editor of the well-respected financial publication Forbes Magazine, once said, “You make more selling advice than following it. It’s one of the things we count on in the magazine business, along with the short memory of our readers.”
Scores of publications sell advice on their proprietary investing secrets. In addition, hundreds of thousands of active money managers claim they can “beat the market” and give you above average returns. Usually, “the market” this advice refers to is the Standard & Poor’s 500 Index.
Investing in the S&P 500 Index simply means owning a fraction of every one of the largest 500 companies in the US. No skill is involved at all; a third grader can do this.
Accepting average market returns through an index fund is termed “passive” investing, while trying to beat the market is called “active” investing. Enticing as the latter may seem, very few active investors manage to do it.
A recent study cited by Dimensional Fund Advisors found that only 17% of money managers beat the S&P 500 Index over 15 years. A similar study done by Dalbar, Inc. found that over 20 years, just 3% of money managers beat the S&P 500 Index. In other words, 97% of all money managers didn’t do as well as a third grader who invested in the S&P 500 Index.
In addition, active investors generally pay around 1.35% a year in fees, compared to around 0.20% a year for passive investors. According to the Dalbar study, the average active investor earns 3% to 4% less annually than the average passive investor. That’s a really big deal.
With all the research to the contrary, why does active investing flourish? There are three reasons.
First, people are confused. Few investors understand that Wall Street has every financial incentive to keep you confused. So does much of the financial press, because passive investing doesn’t sell papers or magazines. We don’t see headlines reading, “What You Need To Do With Your Portfolio Now: NOTHING!”
Second, people tend to be extremely overconfident. Most of what people mistake for outperformance in a money manager is actually just dumb luck. According to Ken French, professor of finance at Dartmouth, it takes 64 years of data to sort through all the random probabilities to assess whether a manager’s short-term beating the market is due to skill rather than chance.
To emphasize this, try an experiment that can make you a stock-picking genius. Select 64 people, preferably not friends. Tell 32 of them the price of a share of Apple will be higher at the end of the month; tell the other 32 it will be lower. Of course, your “prediction” will be true for one group or the other. At the end of the month take the “true” group, divide it into two groups of 16, and repeat the exercise. At the end of the second month, divide the “true” group in half and repeat. Continue the pattern with the remaining 8, then 4, and the last 2. After six months you will have correctly predicted the movement of Apple stock to one person—who will think you are a financial genius.
The third reason active investing flourishes is the superior skill of the top 3%—the Bill Millers and Jim Simons. Such investment gurus provide encouragement that you, too, can beat the market. Yet actually, the fact they exist is exactly the reason why you shouldn’t try. Why? In order for them to do better than the market, they need lots of others to do worse. As Ken French reminds us, trying to beat the market is a zero sum game.