Do Professionals really beat the market? Or it’s a Paradox

How concerned should we be about the cyclical performance of fund managers or of our own portfolio? blog

Performance differences, relative to a market benchmark, don’t really matter over the long-term. Short-term (months or years) under-performance is a fact of life if you are trying to beat the market.

Investors are better off investing in an index fund if they can’t deal with this fact. Otherwise, with human behavior being what it is, investors who can’t accept this fact will buy high and sell low –destroying their wealth in the process.

Volatility and the cyclical performance of active management (i.e. investors trying to beat the market) are really blessings in disguise for long-term investors. 

This might sound strange but it’s true. Columbia Business School professor and successful investor Joel Greenblatt explains why in his excellent book: The Little Book that Still Beats the Market.

The point is that if the magic formula* (Market Fox: or any investment strategy for that matter) worked all the time, everyone would probably use it. If everyone used it, it would probably stop working. So many people would be buying the shares of the bargain priced stocks selected by the magic formula that the prices of those shares would be pushed higher almost immediately. In other words, if everyone used the formula, the bargains would disappear and the magic formula would be ruined!

That’s why we’re so lucky the magic formula isn’t that great. It doesn’t work all the time. In fact, it might not work for years. Most people just won’t wait that long. Their investment time horizon is too short. If a strategy works in the long run (meaning it sometimes takes three, four, or even five years to show its stuff), most people won’t stick with it. After a year or two of performing worse than the market averages (or earning lower returns than their friends), most people look for a new strategy— usually one that has done well over the past few years.

As Greenblatt points out, if identifying good investments is easy, everyone would do it and soon there would be no investment opportunities left. The market would then be efficient and by definition it would be impossible to beat.

Fortunately we don’t have that problem. Every long-term investment strategy – even the most successful strategy – will experience periods of poor performance.

This is both desirable and necessary. Periods of poor performance relative to the market create a fresh crop of opportunities; but only for those who are patient and disciplined enough to maintain a long-term perspective.

Investors that would like to try to beat the market need to come to terms with this fact. Otherwise, they will be much better off investing in an index fund.

The sad fact is that investors invariably lose their patience, give up and sell out. Fund managers also capitulate and give into the pressure to change their strategy, as Greenblatt explains.

Even professional money managers who believe their strategy will work over the long-term have a hard time sticking with it. After a few years of poor performance relative to the market or to their competitors, the vast majority of clients and investors just leave! That’s why it’s hard to stay with a strategy that doesn’t follow along with everyone else’s. As a professional manager, if you do poorly while everyone else is doing well, you run the risk of losing all your clients and possibly your job!

Many managers feel the only way to avoid that risk is to invest pretty much the way everyone else does. Often this means owning the most popular companies, usually the ones whose prospects look most promising over the next few quarters or the next year or two.

Once again, we have another example of the principal and agent problem at work!

Beating the market is a paradox: to win over the long-term you have to be prepared to accept that sometimes you will under-performover the short-term.

Most investors and fund managers are temperamentally unable to do this. Instead, they fool themselves into thinking that they can beat the market by investing the same way as each other, by investing in portfolios that are over-diversified or that have a high degree of overlap with a market benchmark. The result, no surprise, is that they under-perform after fees, costs and taxes.

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