Why We Don't Try To Beat The Market
Georgie has come to the end of her European adventure. Anyone who follows her on Instagram will have seen the amazing photos of the family having the time of their lives, hiking in the French Pyrenees, sailing around the stunning coasts and islands of Croatia, and spending time with the family in the UK.
Meanwhile, in between keeping the office running (and the plants hydrated), I have had the chance to have some amazing father-son bonding with Rocco. He is about to turn one and has just managed his first, wobbly steps.
Months ago, we placed bets on when Rocco would start walking. We made educated guesses. But they were just that. Guesses. There was no way to know for certain when he would start walking. There were just too many variables. The range of potential outcomes was too wide. And whilst we might have been able to influence the outcome, we couldn’t control them. That’s because Rocco’s development is part of a complex adaptive system.
A complex adaptive system is one where there are “agents” that act on their own agenda (which is always changing and attempting to anticipate change in its environment) but then interact with each other to create a system. A human body is an example of a complex adaptive system, as is the weather or an economy or a stock market.
A feature of systems like this is that they are unpredictable and they create a world that is much more random than we might think.
But we humans aren’t good at dealing with unpredictability and randomness so we try to make sense of it and, even worse, we try and make models and predictions from the models.
The models consist of inputs and assumptions and correlations. To get the right output and have any chance of extrapolating that into the future, all of those things have to be correct.
Let’s think for a moment about forecasting an economy. Howards Marks writes:
“A real simulation of the U.S. economy would have to deal with billions of interactions or nodes, including interactions with suppliers, customers, and other market participants around the globe. Is it possible to do this? Is it possible, for example, to predict how consumers will behave (a) if they receive an additional dollar of income (what will be the “marginal propensity to consume”?); (b) if energy prices rise, squeezing other household budget categories; (c) if the price for one good rises relative to others (will there be a “substitution effect”?); or (d) if the geopolitical arena is roiled by events continents away? “
No model is capable of truly modelling such complexity, especially when you throw into the mix a wholly unpredictable left-field event like a war, or global pandemic. The ironic thing is that it’s at those inflection points that the models would be most valuable.
As investors, the problem comes when we start to rely on forecasts or think that we have some knowledge about what is going to happen next.
Yet every single day you can read about a money manager who is doing exactly that. They are investing in 'A, B or C' because this is the future path of interest rates or inflation or commodity prices. They claim that this knowledge is an edge for them – it’s how they can do better than other investors.
It should always set alarm bells ringing.
The promise of performance can be very tempting and the world of ‘wall street’ is still driven by this promise – but the data shows us time and time again that it is almost impossible to continually beat the market.
Only 3% of professional US equity managers outperformed the benchmark in the 20 year period to the end of 2022. That means 97% of managers failed in their promise. International funds fared almost as badly with 6% outperforming. These figures are worse than abysmal. And the funny thing is that they keep promising!
Another reason why it’s so difficult is that nearly all the market’s return comes from a remarkably small number of stocks – giant winners that rise in value by 10,000% or more over the course of decades (aka “Superstocks”).
The chance of being able to consistently pick those Superstocks is miniscule. Note I said ‘consistently’. Sometimes managers get lucky and have a good streak (normally when a decent sized bet pays off) but in the long-run the constant reacting, the ‘in-and-out’, the doing-the-wrong-thing-at-the-wrong-time-for-the-wrong-reason, leads to an erosion of returns.
Burton Malkiel, the famed economist, said recently:
"The evidence just gets stronger and stronger… It's not that nobody outperforms, but it's like looking for a needle in a haystack, and I say more than ever, buy the haystack instead."
And there’s the key – don’t look for the needle in the haystack, buy the haystack instead.
What he means is, instead of trying to find that superstar manager that can consistently outperform the market (you simply won’t find him or her), take a low cost passive/index approach to investing.
Jason Zweig believes investors have “sacrificed over $1 trillion in wealth by investing in funds mostly run by stock pickers instead of buying and holding a market-tracking S&P 500 index fund.”
A similar study found that funds holding more stocks tended to generate higher returns. So, the answer is simple, right? Hold a globally diversified portfolio of the great companies of the world at the lowest possible cost. Still not convinced?
As one of our favourite financial podcasters, Josh Brown, put it:
“One reason an indexing approach has been so successful versus active stock picking is that most stocks end up on the trash heap of history while only a slim minority drive most of the market’s returns as they grow. Owning more stocks is better than owning fewer so you don’t miss the ones that work. An index will gradually drop the losers while holding increasing amounts of the winners. An individual manager being able to do this consistently over decades? Much harder. Some would say statistically impossible. And you’re paying higher fees just to find out, with no way of knowing in advance.”
Howard Marks talks about two schools of investors – the “I know” school and the “I don’t know” school.
It’s easy to identify members of the “I know” school:
· They think knowledge of the future direction of economies, interest rates, markets and widely followed mainstream stocks is essential for investment success.
· They’re confident it can be achieved.
· They know they can do it.
· They’re aware that lots of other people are trying to do it too, but they figure either (a) everyone can be successful at the same time, or (b) only a few can be, but they’re among them.
· They’re comfortable investing based on their opinions regarding the future.
· They’re also glad to share their views with others, even though correct forecasts should be of such great value that no one would give them away gratis.
· They rarely look back to rigorously assess their record as forecasters
The “I don’t know" school on the other hand is full of people who generally believe you can’t know the future; you don’t have to know the future; and the proper goal is to do the best possible job of investing in the absence of that knowledge.
You know which school we belong to.
So, what can you do from a practical perspective? Here are a few suggestions:
1. Invest with purpose – have a plan and stick to it, acknowledging that the portfolio is not the plan itself, rather the medium to fund the plan.
2. Hold a globally diversified portfolio of the great companies of the world at the lowest possible cost (déjà vu?) – that way, we know that no one thing we are invested in can go to the moon, but equally, we know there’s nothing in the portfolio that will blow us up. We know that we will get our share of global returns.
3. Realise that the future is always uncertain and entirely unpredictable – don’t try to time the market, or guess what is going to be the next superstock; we know that over the long-term the markets behave rationally, driven relentlessly higher by corporate profits and innovation.
4. Have patience and discipline – these are the only edges we as humans have left; the two edges that technology can’t get rid of. This often means doing nothing when nothing is the right thing to do – by that, I mean, continue to act on your plan and don’t react to short term moves in the markets.
We have no idea what is going to happen next – the world is too complex and random for any human to be able to predict that – but we have a very good idea what is ultimately going to happen, provided we stick to the time-tested principles.
Even though I couldn’t predict the exact date Rocco would take his first steps, I could be close to certain that he would eventually walk.
Guy
guy@libertywealth.ky