“Market efficiency” makes it very difficult for individual investors to “beat the market.”
Making their own decisions, individual investors perform so poorly that on average their investment returns lag behind the returns that one would expect from random stock selection.
The average professional trader does somewhat better than amateurs do, and professionals probably do so, in part, at the expense of the amateurs. However, on average, any actual performance advantage delivered by professionals is significantly less than the average fees they charge for their services. (See: The illusion of superior professional investment manager performance)
Securities markets in modern industrialized countries tend to price traded assets relatively close to their risk-adjusted expected values. When market prices tend to reflect fully all available information about a security, then those markets are considered “efficient.” This is particularly true in the United States with its broad, real-time, and relatively transparent or relatively honest financial markets.
Of course, the media has been filled with stories of industry misconduct and fraud since the market crash. Nevertheless, U.S. markets still do a reasonably good job of providing a highly liquid forum where knowledgeable and willing buyers and sellers can trade at arms length at prices that are determined by supply and demand rather than manipulation.
This relative “market efficiency” makes it very difficult for individual investors to “beat the market.” In fact, academic studies have shown that, left to their own decisions, individual investors perform so poorly that on average their investment returns lag behind the returns that one would expect from a completely random stock selection process. (See: What is the cost to individual investors of sub-optimal portfolio diversification?)
When higher investment costs, increased taxation, and the value of one’s personal time are considered, the efforts of amateur individual investors to “beat the market” become even more clearly uneconomical.
Nevertheless, the illusion that one can beat the market persists very widely. The securities industry keeps telling them it is possible. Brokers push individual security recommendations and individuals buy them hoping to outperform the market. (See: Can you really beat the securities markets?)
Rarely are individual investors sufficiently disciplined to compare their personal portfolio performance against an appropriate market index benchmark. Instead, as a herd, they to move their money into the most recent hot sector, after securities prices have already run up. Many do not really understand their personal performance and substitute costly activism for a more passive approach.
The average professional trader does somewhat better than amateurs do and, in part, probably does so at the expense of the amateurs. Professionals seem able to capture some of a very slight persistence that equity price movements demonstrate over time, while amateurs are ill equipped and insufficiently capitalized to do the same.
The elusiveness of the very slight price persistence demonstrated by securities cannot be overstated.
Professional money managers are more disciplined and scientific about portfolio management, and their methods allow them to capture some of the persistence in price movements from the securities in portfolios that they already hold. Conversely, amateurs tend to sell winners too quickly and hold on to losing securities too long.
It is noteworthy, however, that professionals seem unable to select securities in the first place that will prove to have persistence in their price movements. Professionals just seem better able to manage the situation after they happen to have acquired securities that do exhibit price persistence. Of course, professionals will claim their performance is the result of skill and not luck, but academics have simply not found such skill to be borne out in the manager performance numbers. (See: Distinguishing between true investment skill and luck)
Could individuals invest in a fund to share some of these small excess returns with professionals who capture them? The answer unfortunately is no. On average, any actual performance advantage delivered by professionals is significantly less than the average fees they charge for their services.
Tags: risk adjusted
Personal Financial Planning
- Rational Mutual Fund and ETF Selection (Rational selection of equity and bond mutual funds and ETFs - An Overview
Given the extremely large variety and number of available fixed income and equity investment mutual funds and ETFs, investors need a rational basis to select among them. Without scientific selection criteria and a good understanding of which factors are more or less likely [...])
- Roth IRA Contributions Versus Traditional IRA Contributions for Renters (Introduction: Roth IRA Contributions versus Traditional IRA Contributions for Renters
In a series of articles, The Skilled Investor compares different lifetime financial planning projections for Fran and Fred Frugal to illustrate the relative value of adopting different financial planning strategies. Fran and Fred, both ages 30, are a married working couple with $100,000 in combined annual [...])
- The Economics of the Financial Investment Advisory Industry (Everyone has similar, yet distinct, financial planning needs regarding their families' financial futures.
While more wealthy people (think millions of dollars) have greater complexity to their financial affairs (caused largely by our incredibly convoluted U.S. personal tax codes), everyone needs sophisticated financial lifecycle planning. Whether wealthy or not yet wealthy, families need a personalized way to [...])
- Pay Lower Investment Expenses To Get Higher Investment Returns (
Pay Lower Investment Expenses To Get Higher Investment Returns - Part 1
Excessive investment costs are a plague on your personal financial planning.
Excessive investment expenses are one of the most significant barriers to lifelong family financial security. While financial services industry sales people tell you that you need to pay more to get more, the correct [...])
- The Optimal Investment Strategy for Individual Investors (The Solution - ONLY follow financial strategies that are scientific, passive, diversified, savings focused, risk controlled, low cost, and tax efficient
A previous article, "The Problem - Straight answers about personal financial and investment planning are difficult to find," summarized important reasons why individuals may experience difficulties, even if they are intent upon doing better with [...])
- Monitor and adjust your financial plan in a time-efficient manner – Step 9 of 10 Financial Planning Steps in the Right Direction (CLICK HERE TO READ THE SKILLED INVESTOR's OTHER ARTICLES ABOUT THESE "10 FINANCIAL PLANNING STEPS IN THE RIGHT DIRECTION
Time in life is the most precious and perishable asset that a person has. It should be spent enjoyably and efficiently. Scientific investment strategies that rely on relatively efficient financial markets allow people to minimize their time [...])
- Set a Minimum Portfolio Size Threshold for Mutual Funds and ETFs (
Choose mutual funds and ETFs with a minimum economical portfolio size
If you are going to invest in actively managed funds, then you should want them to have a sufficiently large asset base to fund the necessary research.
If an active fund is too small, then fund management quality can suffer or fees could grow. Index funds [...])
- Conclusion of the Biggest Personal Finance Story of the Past 30 Years ( < <-- Go to Part 4
The Biggest Personal Finance Story of the Past 30 Years - Conclusion
This article concludes our series on the greatest personal finance story of the past thirty years. In this article, we discuss whether the dramatic growth in equity value of the financial services sector indicates that securities markets are [...])
- Schwab S&P 500 Index Fund – Select Shares (SWPIX) achieve a +8 Fund Authority Score (Fund Authority Scores rate mutual funds and exchange traded funds (ETFs) on the most important economic factors that influence individual investors' net long term diversified investment fund performance. The Skilled Investor developed the Fund Authority Score system to provide individual investors with concise, objective, and realistic summaries of mutual funds and ETFs for comparisons within [...])
- Reduce investment expenses and control taxation – Step 7 of 10 Financial Planning Steps in the Right Direction (CLICK HERE TO READ THE SKILLED INVESTOR's OTHER ARTICLES ABOUT THESE "10 FINANCIAL PLANNING STEPS IN THE RIGHT DIRECTION
Even with optimal investment strategies, there is still substantial room to improve upon net investment performance through continued and vigilant focus on controlling investment costs and tax realization.
The fees extracted by the financial securities industry increased substantially [...])
- American Funds – Capital Income Builder Fund – Class A Shares (CAIBX) attain a +4 Fund Authority Score (Fund Authority Scores rate mutual funds and exchange traded funds (ETFs) on the most important economic factors that influence individual investors' net long term diversified investment fund performance. The Skilled Investor developed the Fund Authority Score system to provide individual investors with concise and objective summaries of mutual funds and ETFs for comparisons within investment [...])
- Pay Lower Expenses To Get Higher Investment Returns – Part 2 (
Pay lower investment expenses to get higher investment returns
While financial services industry sales people tell you that you need to pay more to get more, the correct answer is the opposite.
Excessive investment costs are a plague on your personal financial planning. Excessive investment expenses are one of the most significant barriers to lifelong family financial [...])
- Day Trading Is a Terrible Idea (Why Day Trading Is a Terrible Idea
Investing success is built upon the idea of buying an asset at a discounted price, and then holding it for a long period of time as the value of the asset steadily rises due to the expected risk premium inherent in holding your capital in a risky asset. [...])
- The Cost of Investment Counselors When You Pay Investment Sales Loads (How expensive is financial advisor compensation paid via sales loads?
A sales load might be the method that you prefer to compensate your broker or advisor. If your advisor is truly competent and ethical, he may be able to manage properly the inherent conflicts of interest that are associated with commissioned investment product sales. Even if [...])
- How unstable have stock market returns been over time? (Common stock equity market returns have varied widely in the past. The common stock equity risk premium has averaged about 4.1% from 1872 to 2000.
The equity risk premium is the equity market return less the risk free rate of return. The risk free rate of return includes both the inflation rate and the risk free [...])