If, like us, you’re a fan of Sherlock Holmes, you may have noticed that a new 50 pence coin commemorating his creator Sir Arthur Conan Doyle was recently released by the Royal Mint.
The new coin marks the 160th anniversary of Conan Doyle’s birth and features the silhouette of the world’s most famous fictional detective, complete with deer stalker hat and pipe.
The coin set us thinking how, given his extraordinary intelligence and minute attention to detail, Sherlock Holmes would have chosen to invest his money.
Holmes is famous for his use of the science of deduction, sometimes known as deductive reasoning or ‘top-down’ logic. It’s a process that involves linking a series of statements or promises to a logical conclusion.
“It is a capital mistake to theorise before you have all the evidence”, Holmes explains in the 1887 novel A Study in Scarlet. “It biases the judgment.”
Elaborating on the idea in A Scandal in Bohemia, published four years later, he says that if you try to come up with a theory before you have the data, “insensibly one begins to twist facts to suit theories, instead of theories to suit facts”.
So, what has this got to do with investing? Well, the financial services industry is full of people making promises they can’t keep – promises about ‘beating the market’, about picking the best stocks, about market timing and about guaranteed returns.
Much as these offers can be tempting for those of us looking to grow our wealth and adequately fund our retirement, they don’t really stand up to scrutiny.
The truth about beating the stock market
The truth is, markets are hard to beat consistently. Picking stocks in the belief that prices are wrong is like betting on the horses. It can go either way. Not even the professionals are much good at market timing. And as for guarantees, think about this: if there were no risk in investing, why would there be an extra return over cash?
Evidence-based investing is an approach that is grounded in empirical research and the long-term observation of markets and how they work. This is not an approach based on guesswork or gut feeling or hunches or the idea that any single person has some magic formula for seeing into the future. It is an approach based on verifiable facts and observation.
In a world of slick marketing, spin and hype, the idea of respecting evidence is frequently undervalued. As the great Scottish philosopher David Hume once said, “a wise man proportions his belief to the evidence”.
The truth, as academics and organisations like Morningstar and Standard & Poors have repeatedly shown, is that consistently beating the market over the long term is extremely hard. Winning fund managers don’t tend to repeat year-to-year, and even the very few that do tend to capture any additional returns for themselves by charging high fees for their superior skills.
So, why are markets so hard to beat consistently?
- The first reason is competition. Security prices in global markets represent the aggregated wisdom of millions of buyers and sellers, each with their own views of the right price for each stock. New information, like earnings reports or economic data, are factored into prices instantaneously. The ever-increasing speed of information flows and sophistication of trading systems mean getting an edge is tough. And doing this consistently, day after day, is nigh on impossible. Of course, there may be mistakes in prices. But can you pick them, not just today, but every time and act quickly enough to profit from them? Doubtful.
- The second reason is arithmetic. If one investor has a strong feeling about an individual stock being mispriced and profits from buying it, there must be a loser on the other side of the trade. One conventional investor can only win at the expense of another. So investing this way, by trying to outguess the market, becomes a zero-sum game.
- The third reason is cost. Making big bets against the market doesn’t come cheaply. There’s the cost of all that research on individual stocks, the cost of trading, the cost of falling in love with individual stocks or sectors and paying too much for them. Most of all there’s the cost of paying the big salaries and bonuses that the managers demand. So just beating the market isn’t enough. You must beat it by a big enough margin to cover your costs. And you must do it over and over. This means for the end investor, using these traditional funds ends up being even worse than a zero-sum game.
- The final reason is news. Even if your view of a stock’s inherent price is rock solid based on today’s information, what if the news changes tomorrow? A company’s advantage might be undone by new technology (think Kodak) or a disaster (think BP) or a governance crisis (think VW). Predicting prices correctly implies you can predict tomorrow’s news headlines. Do you know anyone who can do that?
What does the academic evidence tell us about traditional money management?
There are dozens of studies illustrating the difficulty money managers have in outperforming the market consistently:
- Professor David Blake at Cass Business School in London has led an ongoing study into the performance of equity funds in Britain and the US. It found that very few funds beat the market over the long term on a risk- and cost-adjusted basis, and that even those funds effectively claw back from investors any additional returns they generate by charging higher fees.
- Professor Eugene Fama (a 2013 Nobel laureate) and his research partner Kenneth French studied the performance of more than three thousand US mutual funds over 22 years. They found that on average the funds lagged the market by about the fees they charged. While some individual managers undoubtedly did outperform, it was almost impossible to discern whether this was due to skill or luck.
- S&P Dow Jones regularly publishes a report (Standard & Poor’s Index Versus Active or ‘SPIVA’) which compares the returns of traditional managers against indexes across different time periods and asset classes in various markets around the world. The overwhelming pattern is that actively-managed funds tend to underperform their benchmarks over short and long periods and funds that do outperform over some periods do not do so over others.
We’re as sure as we can be, then, that were he alive today, Sherlock Holmes would take a pretty dim view of the actively-managed fund industry. Basing a strategy on theories rather than facts is the most elementary mistake an investor can make.
 New Evidence on Mutual Fund Performance: as Comparison of Alternative Bootstrap Methods, by Blake, Caulfield, Ioannidis & Tonks, June 2014
 Luck Versus Skill in the Cross Section of Mutual Fund Returns, by Fama, Eugene F. and French, Kenneth R., December 2009).
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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