Are you Smarter than the Stock Market?
- Carter Hodgson
- Nov 29, 2023
- 4 min read
When I first started learning about investing, I thought that putting my money into the general stock market (i.e., the S&P 500) was too easy and boring. Picking individual stocks would be way more exciting and it shouldn't be that hard, right? I mean, all I had to do was pick some companies that offered consistent growth and profits. After a little bit of research and critical thinking, I could uncover a burgeoning gem like Monster or Apple. Then, put my money into the stock, watch it grow, and end up with an investment return graph like the ones below.
Little did I know that even professionals regularly fail to beat the market. Test your knowledge below to see how well (or poorly) active money managers fare...answer below
What % of Active Fund Managers Outperformed the Market from 2010-2020?
0%50%
0%75%
0%15%
0%33%
It turns out that 85% of active managers failed to beat the S&P 500 index over a 10-year period and 92% over a 15 year period.
From this, you can calculate that only 15% of active managers performed better than the S&P 500. Keep in mind that this doesn't factor in the 1%+ management fee that most money managers charge and the tax disadvantages when trading short-term. So, the number is likely less than 10%.
This means that paid professional investment managers who spend 40+ hours per week and have years of experience vetting investment opportunities can't beat the general index. If this doesn't convince you that stock picking is at best hard and at worst extremely impractical, then maybe these next points can get you over the hump!
Factors that Make Outperformance Very Difficult
You need an edge in the market (behavioral, informational, or analytical)
This could look like having unique expertise on the company, using your critical thinking skills to assess the trajectory of the company, or maintaining steadfast conviction in the company's potential. Individual investors are not likely to have any of these as investment professionals likely have greater or equal informational and analytical capabilities. And, it takes incredible emotional control to never sell a stock, especially after seeing drawdowns in excess of 20%.
The market is generally very efficient
With the advent of technology in the 21st century, accessibility to information, influx of capital, and reduction in retail trading (proportionally), inefficiencies are much harder to come by. Institutional investors (asset management firms, banks, insurance companies, hedge funds, etc.) pounce on market inefficiencies very quickly – leaving little opportunity for outperformance outside of small, illiquid stocks.
The Law of Mean Reversion
Investors tend to buy things that have performed well in the past. Click the link to visually see this concept where buyers may purchase a stock on an upcycle but the stock will eventually return to its gradual growth rate (the line). For example, let's say Tesla's fair value is $100 but it shoots up to $120 (a 20% gain), so you buy it as the stock looks favorable. But, 6 months later, Tesla reverts back to its fair value of $100. This results in an unrealized loss for the investor.
The chances of picking a long-term winner are very slim
When thinking of perenially great stocks, we picture companies like Apple, Google, Amazon, Microsoft, Berkshire Hathaway, and more recent names like Tesla and Nvidia. However, those are only a very very small fraction of the 3000+ stocks that trade on any given day. So, you'd have to find the top 1% of stocks and hold onto them for years and years, resisting the psychological phenomenon of loss aversion. This is hard for even the MOST disciplined investors.
Hendrick Bessimbineder has shown that less than 100 stocks have been responsible for over 50% of wealth creation since 1926. That means that out of 3000 stocks trading in any period, less than 4% are truly winners. This percentage is actually much lower as stock turnover must be accounted for, where new companies join the public sphere while others go private or bankrupt. Further, Treasury bills outperform nearly 60% of stocks throughout their lifetime and 55% of stocks produce negative returns in any given 10-year period. Isn't that frustrating given the extra return potential touted by stocks!
Average stock lifespans are going down
The average public company lasts less than 20 years nowadays, compared to over 35 years in 1980. This is due to the rapid innovation and technological advancements that are leaving many companies struggling to adapt to the changing times. Many expect this trend to continue, resulting in more turnover in the future. Looking at the history of Dow Jones – an index comprised of 30 of the most prominent US companies – we can find examples of frequent turnover. Since 1928, General Electric was the longest-tenured company in the Dow, removed in 2018. That's a very long 90 years, but many original companies were delisted in 30 years or less. Further, only 15 companies (50%) listed on the Dow in 2000 remain on the 2023 list.
I hope the points listed above make you think twice before stock-picking, but if not here's one more chart to hammer the point.
This graph shows that the average stock underperforms the Russell 3000 Index by more than 50% over its lifetime. Again, extreme winners are not the norm, but rather the anomaly paired with some good fortune.
However, this does not mean that you have to avoid stock-picking entirely.
Many professionals and everyday individuals find joy in learning about individual companies, believe in their ability to overcome the odds, want to be a part of a company they truly believe in, and love the excitement that picking stocks brings to their lives.
If you find yourself in one of these boats above, then you can take a small portion of your savings and pick stocks that you believe will perform well. I wouldn't recommend taking more than 10% of your savings to do this, as you want a large chunk of your portfolio to be very diversified and more resilient against idiosyncratic risk.
Remember that diversification and starting early are the keys to building a durable and budding investment portfolio, but you can still have some investing fun along the way!
https://www.cnbc.com/2020/09/18/stock-picking-has-a-terrible-track-record-and-its-getting-worse.html
This really makes it sound like stock trading is just another form of gambling with a degree of information involved. If I'm gonna gamble on informed opinions, why would I do it on something as boring as businesses successes.