You don’t need to beat the market

Much of the mainstream media commentary around investing carries with it the assumption that everyone’s goal should be to try to ‘beat’ the market. But what does that mean? And does it make any sense at all?

Even the idea that ordinary investors can consistently do better than the market, after allowing for risks and fees, is a fanciful one. The truth is, even the pros struggle to outperform the market year-in, year-out.

Of course, you will hear of outliers like Warren Buffett of Berkshire Hathaway or Peter Lynch of the Magellan Fund who seemed to hold out hope that delivering market-beating returns for years is within everyone’s grasp.

But the record shows that most managers struggle to beat benchmarks over long time periods and that those that do in the short term don’t tend to repeat their successes over an investment lifetime. Acknowledging that there are some talented managers doesn’t solve the problem that investors need to be able to find them and invest in them ahead of, not after their success.

Distinguishing luck from skill

Another issue for those of us trying to pick the best managers is separating luck from skill. A famous academic paper in recent years looked at the performance of US mutual funds over 23 years and found few funds produced returns sufficient to beat the market after costs.

This isn’t to say there aren’t skilled managers. But think about this: if those managers do have sufficient skill to beat the market year after year, why would they not capture all of those excess returns themselves? Why would they share it with the wider public?

In any case, what is advertised as skill is frequently just what is there for the taking. In recent years, what managers advertise as ‘alpha’, the skill that enables them to beat the market, has increasingly been exposed as ‘beta’ – the return you can earn without trying to outguess the market.

The behaviour gap

But while the various camps in the asset management industry slug it out over how much value they add, the challenge for most investors is just getting the market rate of return. Studies like the annual DALBAR analysis of investor behaviour regularly find a significant gap between what the market offers and what average investors receive.

People underperform the market mainly because of their own behaviour. They are more sensitive to losses than gains, they chase past winners, they fail to sufficiently diversify, and they try, in vain, to time the market. They also ignore boring, but important factors like costs and taxes.

A lot of this bad behaviour results from people thinking that their goal should be to ‘beat’ the market. In fact, their real goal is to earn the market return, and do it consistently, and at low cost so that they maximise their chance of securing the long-term returns they need to live the life they want.

Short-term market movements are unpredictable

The fact is, market returns are unpredictable. And that, in part, is because news is unpredictable. Economies are fluid; growth accelerates or slows; companies rise and fall; once dominant industries succumb to technological evolution; and consumer preferences are always changing.

Markets price all this news instantaneously, reflecting collective expectations for future returns. Trying to outguess the market means second-guessing those prices, which is a haphazard occupation at best.

You may, of course, be right, but you’re just as likely to be wrong. And remember, to outperform consistently you need to keep on making correct calls time and again, and hope that any gains you make at least offset the costs involved in active trading.

Follow Warren Buffett’s advice

Even Warren Buffett, the doyen of stock pickers, has argued that most people would be better off in a low-cost index fund. And he famously won a $1 million bet that these boring ‘passive’ funds would do better than most expensive and elaborate hedge funds over a decade.

So, while the idea of beating the market is an attractive one, the reality is that most people are more likely to get ‘beaten up’ by the market. And they do so primarily because of a refusal to just accept that prices, however imperfect, reflect the aggregate of all market participants’ best estimate of future returns.

From this research, Carbon’s second guiding investment principle was born over 10 years ago: “Markets work – don’t try to pick shares or managers, just diversify”.

The value of investments and the income derived from them can fall as well as rise. You may not get back what you invest.

This communication is for general information only and is not intended to be individual advice. It represents our understanding of law and HM Revenue & Customs practice. You are recommended to seek competent professional advice before taking any action.

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