Let’s begin this blog post by looking back one decade. I was sitting at the local university listening to my professor teaching me about the stock market: “And as you can all see – the stock market is unbeatable…”
For a long time I thoroughly believed him. Why wouldn’t I? My professor was a really smart man, and gave his lectures with a strong conviction. The massive text book I was required to read for the course said the same thing: “The stock market is unbeatable”. Today, I honestly think it was a bit superfluous to have a whole course about an efficient stock market. After all what will you be taught when everything is always prices right? How much do we really need to think for ourselves?
After I graduated I got a job as a commodities trader. While commodities and stocks are different I quickly learned that the markets are not “efficient” as it was called in academia. That is that the stocks and other financial securities are always prices right. As a result of this I started to think back at my classes and wondered if my professor (and myself) had been wrong about the unbeatable stock market.
If you wonder how academics prove that the market is unbeatable, it goes something like these 3 steps:
- People that wants to beat the stock market must apply “active investing”
- Mutual funds are proponents for active investing
- Mutual funds don’t beat the market consistently
While this seems like a very reasonable approach I think it raises some serious questions. The first one is…
Why do mutual funds not beat the market?
I will give academia this: They are completely right when they say that mutual funds don’t beat the market. That is actually not my point at all. But first let’s examine why:
- Mutual fund managers can’t underperform the market. This is actually quite ironic. Since mutual funds need to consistently beat the market quarter after quarter, and most importantly not underperform, the managers tend to invest very short sighted. That means that they can’t really look too much at the fundamentals, but looks too much of the momentum of stocks. It’s a hard game to play, and the rapid changes in their portfolios incur a lot of transactions costs and taxes that are reflected in their returns.
- Mutual funds are by definition not consistent. What happens if a mutual fund does well? Typically it attracts a lot of new capital from investors that wants to invest with the best return. It rarely turns out to be the case. More capital are harder to compound, and the extra capital might even force the managers to apply another strategy, because the old strategy that worked might only be applicable for fewer funds. What also often happens is that the brilliant portfolio managers got a job with another fund because of his previous performance. No matter the exact reason, inherently mutual funds have a hard time being consistent.
- More reasons. There are plenty of other reasons why mutual funds don’t outperform the market. We haven’t even talked about the horrific fees they charge, but even if we exclude that it’s still hard to outperform the market. However, my point is that mutual fund performance is not the correct methodology chosen by academia to determine if the market can be beat. Mutual funds are just one of many different approaches to active investing, and one that doesn’t work well. It’s like saying that you can’t make a living out of sports and forget football, basketball, baseball, and only focus on the disciplines that few wants to sponsor or look at.
But what about Warren Buffett?
Every time the discussion comes if the market can’t be beat, someone always bring up Warren Buffett. Surely he must be the proof even the most stubborn critique of the unbeatable stock market – right? Well, unfortunately not. The “coin flip example” comes up to explain that Buffett is not the greatest investor, he is rather just the luckiest. I remember my old professor first introducing me to the concept. “When you have enough people flipping a coin someone will ultimately win more than others – and that person is Warren Buffett”. Well, my professor was a humorous man, and always added: “But I drive a Kia – so I might be wrong”.
The great thing is that Warren Buffett was presented the argument by Professor Michael Jensen, one of the most famous and well respected economists in financial economics. Buffett’s argument were that he couldn’t understand how 9 investors, all members of Benjamin Graham’s exclusive alumni could all flip straight heads for 20 years with different portfolios. Here’s a great Wikipedia article about the event at Columbia University in 1984 about the “Super Investors of Graham-and-Doddsville”. While some of these 9 super investors are known to have a modest consumption compared to their net worth, I’m quite confident that no one drives Kia.
So where is your proof that the market is beatable Stig?
Admittedly, the stock market, which is often referred to as S&P500, is hard to beat. To understand why, let’s see what an index is. S&P500 is 500 very large American corporates that are all listed, and selected by a committee based on their market cap, trading volume, and a few other criteria.
The reason why this is so hard to beat, is that the performance is measured by a long term buy and hold strategy. That is actually the secret! By holding on to the index you don’t let your emotions determine when to buy and sell, which most people do wrong. The stock market as a whole is actually quite simple (not easy) to beat. Even if you are not Warren Buffett or a super investor, it’s easy to find prove that the market is beatable. If you looked at S&P500 and invested in the 50 cheapest based on their P/E and rebalanced every year, you would surely outperform the S&P500 over the long run. I know what you’re thinking.
If it’s that easy why isn’t everybody doing it, and why do academia still stubbornly argue that you can’t beat the market? The interesting thing is that many people in academia have made numerous studies proofing that the market indeed it not efficient. Whether it’s you are buying the cheapest securities based on P/E, P/B, P/S or any other value investing metric, the conclusion is the same: You can’t beat the market as well as Warren Buffett, but you can beat the market consistently. It’s as simple as it’s true. Still few people follow the approach. Perhaps one of the reasons is that these articles usually don’t get that much attention, and in any case, it doesn’t alter the common theory that is being taught: “You can’t beat the stock market.”
Call me crazy, but I feel I’m a part of a new generation of college professors that believes that the stock market can be beaten. While I don’t teach my student that the market is efficient, I still think that the common misperception of the efficient market is one of the best things that ever happened to investors. Why? Please let me elaborate in my next blog post.
P.s. As usual, I want to hear if my analysis is right or wrong! If you’ve got some comments or questions about this post, be sure to contact me directly.