What does it mean to beat the market?
“Beating the market” means getting higher investment returns than the S&P 500 stock index…[which] is the most commonly used benchmark of overall stock market performance. Historically, it has had average returns of 8-10% per year…
Research: 89% of fund managers fail to beat the market
The S&P Dow Jones Indices regularly researches how actively managed mutual funds perform compared to the S&P500 index and, according to their last report.
- 88.99% of large-cap US funds have underperformed the S&P500 index over ten years.
- As a whole, 78-97% of actively managed stock funds failed to beat the indexes they were benchmarked against over ten years.
- In addition, all professional fund investing styles under-performed the market — large caps, mid-caps, small-caps, all-caps, value, growth, etc.
The longer the funds are measured for, the greater the likelihood of them under-performing their benchmark indices. It is relatively common to beat the market for 1-3 years at a time – that can largely be explained by luck – but the data clearly shows that even professional fund managers are unable to beat the market consistently over a longer period of time, like 10-15 years.
Most hedge funds also under-perform the market
Hedge funds are investment funds that often use complicated strategies to achieve better returns than the market but, contrary to popular belief, most hedge funds actually perform worse than the market, on average — far worse…In the year 2016, the hedge funds had returned 22.04% on average while the S&P500 had returned 85.4%, almost four times as much.
Part of the reason for this is that hedge funds have very high fees. It’s common for them to charge a 2% annual management fee, plus 20% of profits and, because of these high fees, hedge funds are mostly useful for making their owners and managers rich. Most of them drastically under-perform the market.
Regular investors have some advantages over professionals
…Regular investors, however, have some surprising advantages that can possibly give them a slight edge over the professionals.
1. No management fees
A big part of why professionally managed funds and hedge funds under-perform is [because of] the high fees they charge so, even if they were able to beat the market slightly, they end up under-performing the S&P500 when the fees have been subtracted from the returns. A regular investor, [on the other hand,] does not need to pay management fees, only trading commissions and taxes [and] many brokers offer commission-free trading these days, and it is possible to reduce the taxes by investing in a tax-advantaged account like a 401(k).
2. No career risk
Most professional funds take a cut of the total amount of money that they manage, often in the range of 1-2%…[and, as such,], these funds are incentivized to maximize their total assets under management, not maximizing returns…
If they try to beat the market by taking risks, the chances are high that they will end up drastically under-performing the market for some quarterly or annual periods and when that happens, investors are highly likely to pull their money out of the fund, causing the fund manager to lose money or even get fired. This is called “career risk.”
Fund managers need to worry about the safety of their careers when deciding what to invest in and one consequence of this is that many professionally managed funds end up becoming “closet indexers”, that is, they invest in a lot of the same companies that are in their benchmarks, so they end up mostly tracking their benchmarks. Regular investors don’t have to worry about this. They can stick with high-conviction bets without having to worry about getting fired and this is important because good investments often under-perform before they end up outperforming.
3. Smaller size
The more money you have, the harder it will be to beat the market. As a small investor, no one is keeping track of what you are buying or selling…On the other hand, a big fund that starts buying stock will often cause the price to move up because the demand for the stock then outweighs the supply and, when a big fund starts selling, it can cause the price to go down and because of this, the sizes of big funds cause them to have reduced performance…
Because most regular investors have very small portfolios compared to big funds, this gives them a size advantage. They can buy and sell at better prices.
4. More varied investment options
Having a lot of money under management limits the investment options. Someone with tens of millions of dollars won’t be investing in small-cap stocks, for example, because
- the returns are unlikely to move the needle for the fund as a whole,
- the effects of the fund’s buying or selling on the price of a small-cap stock,
- many funds have strict mandates about what they can and can not invest in and
- many funds are also forced to remain mostly invested at all times (because, if a fund sells everything and goes to cash for an extended period, then the clients are likely to pull their money out).
Regular investors don’t have these restraints. They can
- invest in small- and mid-cap stocks,
- buy different types of investments if they can’t find any stocks that look attractive and even
- go part- or all-cash if they think the risk of staying invested outweighs the potential rewards (although trying to time the market in this way usually fails).
Why stock picking can still be a good idea
Passive investing in index funds may be the best approach for regular people who aren’t that interested in the stock market but simply want to build enough wealth to retire comfortably one day but for people who have a passionate interest in stocks and investing, there is absolutely nothing wrong with picking stocks.
Stock picking is fun, and it can lead to immense rewards if you pick a few stocks that end up performing really well. For example, if you had invested even a small percentage of your portfolio in stocks like Apple or Amazon a decade ago, you would have made a lot of money. Thinking about a stock as representing part ownership of a company is a good idea. Don’t just buy it because you think it will go up, buy it because you believe that the company is going to do well in the future. If you buy solid companies with good future prospects at fair prices, then you are likely to make money from your stock picks over time. If you want to hedge your bets, then you could put 50% or even 90% of your stock portfolio in an S&P 500 index fund, but then use the rest to pick individual stocks then, if you end up under-performing the market, at least it won’t be by as large of a margin because you had a big chunk of your money in an index fund.