Is it Impossible to Beat the Market?

Is it Impossible to Beat the Market?

The efficient market theory, proposed in the 1960s by the “father of modern finance,” Eugene Fama, is the concept that the price of stocks, bonds, and other securities fully reflect all available information at any point in time. The idea is that profit-maximizing investors tirelessly searching for information and using what they know, including what they think will happen in the future, have and always will trade securities to their precise fair valuation at any given time. This therefore implies that individual investors cannot “beat the market,” or in other words find securities that are mispriced in order to create a portfolio that consistently performs better than the broad market as a whole.

The efficient market theory suggests that an individual investor is better off investing in a broad market fund rather than try and pick individual stocks. Statistics agree with this hypothesis. According to a study by Dalbar Inc., a company which studies investor behavior and analyzes investor market returns, the average investor earned 2.1% annually over the past 20 years. This compares with 7.8% annual returns for the S&P 500 and 6.5% returns for the Barclays Capital U.S. Aggregate Bond Index. To make matters worse, after including an annualized inflation rate of 2.5% over the same time period; average investors end up with a real rate of return of -0.4%. While this loss is less than you would incur by hiding your money under your mattress it’s certainly no way to grow your personal wealth over time.

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Study after study show that this dismal performance is due to the fact that individual investors only become interested in the stock market when it has gone up significantly and so become willing to invest their own money. The opposite is true after the stock market has gone down significantly and then those same investors sell those stock holdings at a significant loss. This “buying high and selling low” strategy is the exact opposite of the well-known Street mantra of “Buy low, sell high,” and a guaranteed losing strategy.

The primary reason for this disconnect in behavior is that the average investor tends to invest based on emotion rather than fundamental evaluation. For example, when the market bottomed in March 2009, investors should have been looking to buy companies selling at a discount, but instead they did the exact opposite and sold their holdings at large losses out of fear. In true contradictory fashion the opposite is taking place today. Since 2009, the S&P 500 has risen 190% and average investors are feeling the disappointment of having been left out of spectacular market returns. To quell that emotion investors are buying into a market that is beginning to look overvalued by many metrics, exactly the time when professional investors may be looking to sell holdings and take profits. There are many psychological studies that back up this hypothesis, rather than cite them here I think it’s safe to state that according to statistics individual investors are generally poor stock pickers.

The fact that the market was so undervalued back in 2009 offers a reason to question the credibility of the Efficient Market Theory. How could we have reached such depressed levels if all available information is priced into the market? At the other end of that spectrum, how could we reach “bubble territory” such as we had in 2007 which directly led to the 2008-2009 crash to begin with? Again I see the answer to those questions being human emotion. Traders, whether institutional or individual, can all ultimately succumb to emotion when investing; thus providing opportunities for those that are observant.

To recap, statistics show that average investors are much better off investing in broad index funds rather than trying to pick individual stocks. On the other hand, history shows that even the broad indexes can be erratic at times, reaching absurd levels of both overvaluation and undervaluation, ultimately disproving EMT. So what, if any, options are available?

There are countless examples of investors that do consistently outperform the overall market, evidence of which provides another blow to the credibility of the Efficient Market Theory.  What these investors have in common is their knowledge of the market and their ability to search for value due to market distortions while leaving emotions at the door. One of the most well-known examples of investors who consistently outperform the market is Warren Buffet. Buffet’s holding company, Berkshire Hathaway, has had an annual investment return rate of 20% over the past 45 years.

“Risk comes from not knowing what you’re doing.” -Warren Buffett

George Soros, a lesser known hedge fund manager, provided returns in excess of 30% per year for more than a decade to his shareholders.

“Once we realize that imperfect understanding is the human condition there is no shame in being wrong, only in failing to correct our mistakes.” -George Soros

Another fund manager, Carl Icahn, compounded his investments from 1968 through 2011 at a 31% annual rate.

When most investors, including the pros, all agree on something, they’re usually wrong.”

 -Carl Icahn

The takeaway here is that investing on your own can be detrimental to your financial future if you aren’t knowledgeable about your investment choices. If your decision is to invest on your own then statistics suggest you should invest in a broad market index. However, as has been pointed out; it is possible to outperform the broader market and significantly grow your net worth over time. The key is finding a professional with the necessary skills and the fiduciary responsibility to have your best interests at heart.

 

 

This article contains the opinions of the author but not necessarily the opinions of Vulcan Investments, LLC. The opinion of the author is subject to change without notice. All materials presented are compiled from sources believed to be reliable and current, but accuracy cannot be guaranteed. This article is distributed for educational purposes, and it is not to be construed as an offer, solicitation, recommendation, or endorsement of any particular security, product, or service.