“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: optimal portfolio
Personal Financial Planning
- Fidelity Spartan 500 Index mutual fund (FSMKX) achieves the Best +10 Fund Authority Score (
The Standard & Poors 500 stock index is the most common equity index fund benchmark in the U.S. The S and P 500 tracks about 75% of publicly traded U.S. equity market asset value. The dominant issue in choosing among passively managed index mutual funds and ETF funds benchmarked against the S & P 500 [...])
- Most Individual Investors Are Poor Personal Portfolio Managers (Most individual investors are poor investment portfolio managers
Investors more easily understand investment costs that are directly measurable, such as fees deducted on investment statements. However, many investors ignore or are unaware of the “opportunity costs” of their sub-optimal investment behaviors. Opportunity costs are usually much more difficult to measure directly, but these investment costs can [...])
- Understand the Confusing Securities Market Motion Picture (
Securities markets are usually very quick to adjust prices to reflect new information. However, this price adjustment process may take longer and be more volatile, if the new information is ambiguous.
At any point in time, market participants will already have used more or less rigorous valuation methods to judge their expected risk-adjusted value of securities. [...])
- Time Spent on the Wrong Financial Activities Is Bad for You (
Spending your valuable time on the wrong financial activities is just plain bad for you
A previous article, “The Solution - ONLY follow financial strategies that are scientific, passive, diversified, savings focused, risk controlled, low cost, and tax efficient,” suggested that individuals are much better off with a well-considered financial viewpoint. This follow-up article discusses the [...])
- Use Caution with Classical Investment Books (Use Caution with Classical Investment Books - A Tip from The Skilled Investor
Individual investors should exercise caution when applying the tactics of classical investment books to current markets. The more handcrafted, seat-of-the-pants, and individual actor approach to the securities markets in the pre-computer, pre-networking era has given way to different practices. What might have worked [...])
- Always Completely Diversify Your Investment Portfolio (Complete portfolio diversification is always a better idea.
On average, the securities markets will not pay you to hold any skewed subset of the overall market. Doing so is just a gamble that may or may not pay off. You should not expect to be paid any more for the added risk and anxiety.
A previous article, [...])
- American Funds – Growth Fund of America – Class A Shares (AGTHX) collect a +2 Fund Authority Score (
The investment fund objective of American Funds' Growth Fund of America
With 4.4 million shareholder accounts, the Growth Fund of America (AGTHX) is the largest actively managed stock mutual fund in the United States. According to American Funds prospectus, the investment objective of the Growth Fund of America "is to provide you with growth of capital."
- Where’s Waldo? – The illusion of superior professional mutual fund manager performance. (If investment mutual fund managers were truly skilled at beating the market, then you would expect mutual fund manager performance prowess to persist over time.
Unfortunately, the evidence indicates that superior past professional performance among mutual fund managers tends not to persist. Past superior mutual fund performance is simply not a predictor of future superior mutual [...])
- What Is Investment Portfolio Diversification? (From the perspective of holding a well-diversified investment portfolio according to scientific investment principles, the objective of diversification is to minimize or eliminate ‘unsystematic risk’ or those risks that are not related to the price volatility of the overall securities markets.
When people speak of investment diversification, they may mean different things. Therefore, clear definitions are [...])
- Financial Industry Product Development and Your Best Interests (
Financial research drives industry product development, but not necessarily toward the best interests of individuals
Personal financial decisions seem to have become very complicated. To add to the confusion, the financial services industry develops an unending array of supposedly innovative new products. However, a large part of the complexity that individuals face results from the proliferation [...])
- 15 Value-Added Individual Investor Activities (Before estimating the investment value that you might add or take away from your portfolio, you first need to determine whether your strategies are or are not likely to lead to optimal risk-adjusted investment returns.
This value estimation is separate from any hourly opportunity cost related to spending time on your investments versus an alternative use [...])
- Two Examples of the Tax Assets Graphic in VeriPlan (Two examples of the Tax Assets graphic in VeriPlan
TAX ASSETS: Taxable and Tax-Advantaged Financial Assets (real $/yr)
Below are two examples of the blue-tabbed TAX ASSETS graphic, which come from VeriPlan's "Sue and Sam Saver" tutorial. This graphic separates their cash, bond, and stock assets by account taxability throughout their lifetime projections. Assets are separated [...])
- 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 [...])
- Commentary on How Many Mutual Funds are Needed for a Well-Diversified Portfolio (
For holding periods of many years, diversification improves dramatically, when you hold multiple actively-managed mutual funds in an investment portfolio.
In "How Many Mutual Funds Constitute a Diversified Mutual Fund Portfolio?," Professor Edward O'Neal of the University of New Hampshire at Durham tackled the important question of how much an investor could improve on diversification by [...])
- When to Take Social Security Retirement Benefits (When to Take Social Security Retirement Benefits?
Concerning when to take Social Security retirement benefits, the Boston College Center for Retirement Research has some research in their publications section that addresses this subject. In particular, see "SHOULD WE RAISE SOCIAL SECURITY’S EARLIEST ELIGIBILITY AGE" by Alicia H. Munnell, Kevin B. Meme, Natalia A. Jivan, and Kevin [...])