Stop Chasing the Market!

Does anyone constantly beat the market? In other words, are there investing “experts” who consistently pick more winners than losers? The quick answer is “yes.” The right answer is bit more complicated.

To arrive at a better answer, we need to ask a few more questions: How many of these market “experts” are there? What is the most likely reason for their success? Can you identify those who will be successful in the future?

The exact number is elusive. In 2013, investment (speculation) newsletter researcher, Mark Hulbert of Hulbert Financial Digest, found that just over 25% of the market prognosticators he followed (51 out of 200) beat the broad U.S. stock market (Willshire 5000) over 10 years.

Read the Wall Street Journal article

That’s not very impressive when you consider the fact that these market “gurus” charge for and publish their predictions on a regular basis. They can be considered the “major leagues” of market prediction. If the big hitters don’t beat the odds, who will?

Are the few who did beat the market prophetic geniuses or is there another, more likely explanation? Let’s turn to a couple of other sources to answer that question:

We’ll start with a firm that has been grading “investing” gurus since 1998, CXO Advisory. The average predictive success rate of the 68 big name gurus (like Ken Fisher, David Dremen, Bob Brinker, Stephen Leeb, Jim Cramer, Gary Shilling) has been 47.4%. That’s less than you would have expected from just flipping coins.

See CXO Advisory's Guru Grades

Is it possible that the winners (fewer than half of the gurus graded) were just lucky? A number of different academic studies have looked at that possibility:

One of the longest and most heavily cited studies was published by Professors Barras, Scaillet, and Wermers in 2009. In their Swiss Finance Institute paper, they looked at the performance of all actively-managed U.S. equity mutual funds between 1975 and 2006 and found that less than 1% of managers exhibited something akin to skill. After deducting expenses and adjusting the returns for the effects of luck, the study found that over 75% of active managers added zero performance, about 24% hurt fund performance, and a mere 0.6% of managers exhibited what seemed to be real skill at adding value.

Download Barras, Scaillet, Wermers paper

Another study by Professors Fama and French, published in the Journal of Finance was a bit kinder to active managers, finding that about 3% appeared to exhibit some stock selection skills after adjusting for luck. Still, that means that, at least, 97% of active fund managers add no value for the fees they charge.

Download Fama, French paper

With somewhere between 1% and 3% of active fund managers showing some talent for picking stocks, the trick to beating the market is finding those good funds, right? All you have to do is accurately predict which managers will be able to accurately predict the future based solely on past performance.

Therein lies yet another problem. Past performance doesn’t tell you much about who will do well in the future. Numerous studies have found that the top performing funds of the past are rarely the top performing funds in the future. Vanguard found that out of the 20 top performing U.S. equity funds from 1983 through 1993; only one managed to end up in the top 100 performers between 1994 and 2004.If active management was taken to court, a reasonable jury would conclude that anyone claiming to be able to beat the market is committing perjury (lying). If most active fund managers do no better than the market (and often quite worse) aren’t they engaging in deception?Take a look at your investments. Do you have any actively managed funds? Ask yourself why you own them. Do you really believe that your funds are among the tiny fraction of funds that will successfully beat their peers in the future? How much do they cost? More than 1% per year? A lot more?

Is it likely you would make more in index funds by merely paying less? Is it possible that a properly-diversified, passive management strategy might be better for you? The answers seem pretty clear.