Who Is Your Competition?
Famed hedge fund manager Michael Steinhardt was once asked what the single most important thing an amateur investor could learn from him was. His arrogant but informative answer was “That I’m their competition.”
Every time you buy or sell a stock or mutual fund there is someone on the other side of the trade. So, apart from Michael Steinhardt, who is your competition when you invest?
Charles Ellis, in his classic investment book Winning the Loser’s Game, reports that in the 1950s and 1960s about 90 percent of stock trades were made by individual investors. Since then, due to the growth of pension funds, mutual funds, hedge funds, and ETFs, the equation has flipped. Now it is estimated that 90 percent of trades are made by investment professionals.
And who are these investment professionals? Most have graduate degrees from top business schools and they have survived a very competitive hiring process at some of the most respected companies in the country. They are the definition of “the best and the brightest.” In addition, they are provided with the latest technology, the fastest computers, and instant access to a wealth of information and data not available to the average investor.
In short, whenever you buy or sell a stock the person on the other side of the trade is most likely smarter than you, more experienced than you, and has resources you can’t match. Under these conditions it is almost impossible for you to beat the market.
The Efficient Market Theory
There is an old joke about a finance professor and a student walking across campus. The student sees a $100 bill lying on the ground and bends over to pick it up. The finance professor tells the student, “Don’t bother. If it were really a $100 bill it wouldn’t be there.” The joke is told to illustrate that it is not easy to beat the stock market.
The reason it is so difficult to beat the stock market is because your competition (all of the intelligent, highly motivated people working on Wall Street) make the market very efficient. This is known as The Efficient Market Theory, which is described by Eugene Fama as follows:
“In an efficient market, competition…leads to a situation where at any point in time, actual prices of individual securities already reflect the effects of information based both on events that have already occurred and on events which, as of now, the market expects to take place in the future. In other words, in an efficient market at any point in time the actual price of a security will be a good estimate of its intrinsic value.”
There just aren’t many $100 bills lying on Wall Street.
There is a lot of controversy in the world of finance about just how efficient the markets are. Obviously the markets are not totally efficient, but they are efficient enough to make it inefficient for you to try and beat them. As Larry Swedroe states “The market may not be perfectly efficient…. The prudent investment strategy, however, is to behave as if it were.”
If You Can’t Beat Them, Join Them
Beating the stock market has never been more difficult for the individual investor than now, but don’t despair. You don’t have to beat the stock market to be a successful investor. Simply matching the market can pay off very handsomely, and matching the market has never been easier or cheaper. It can be done using low-cost index mutual funds or ETFs, which allow you to stop competing with professional investors and join them instead.
We will learn more about index funds later. For now it is enough to admit that, over time, you can’t beat the stock market. So if you stumble on a $100 bill lying on the ground, go ahead and pick it up. Just don’t live your life staring at the ground looking for more. Use index funds instead and spend your time on more enjoyable pursuits.
I agree with you! No one can beat the market.
The odds are definitely stacked against you.
I am working on moving my “costly” portfolio from Edward Jones to very low fee Vanguard Index Admiral funds. My EJ costs are about 1.5%. I can’t afford to pay that over the next 20 years. The experience is like breaking up with a girlfriend who does not want to break up. The broker does everything to hang on.
Sounds like a very smart move. Vanguard has led the way on low cost index funds and I have a lot of respect from them. Good luck with the break up.
Smart move. I broke up with my broker this year when I realized that, just with the money I currently have invested with him, he would cost me $163K in fees (in this case 1%) even with fund choices that have low MERs. I’ve moved to an online discount brokerage firm and am so pleased I did.
I thought it was funny that this post talks about beating the professional investor. Interestingly enough, “only 8/10 of 1% of 355 equity funds that started the race in 1970 have survived and mounted a record of sustained excellence” John Bogle, p. 83 of The Little Book of Common Sense Investing.
The 355 Bogle talks about were all funds managed by investment professionals, and they were the only funds that were still around. The bulk of funds were not even available for comparison because they didn’t make it. What this says is that investment professionals are not the enemy. Trying to beat the market is.
Even the professionals lose when they try to play the game. How do they get rich? On their client’s fees, not not the returns they generate. Index funds held for the long term are definitely the way to go. You can pay less in fees and consistently make better returns than anyone going with a different strategy (low MERs, no trading fees AND you can sleep at night).
Good point. That is, more or less, the direction I plan to take with my next post. Stay tuned.
I look forward to it.
Yes Eugene Fama postulated the efficient market theory however he is also on record saying that can be irrational as well and in that irrationality a person can find profits that can beat the market. The disadvantage that our competition the big money managers have is their size so when they move the market moves because they are the market, where when we move we do not even produce a ripple. Warren Buffet is quoted as saying that if he were investing 1 million dollars he could have a 50% return and he knows investor investing up to 5 million who do. According to Phil Town the key to big returns is treating your purchase of stock like you are investing in a business (check out Rule # 1 investing, and Payback time) which you are. He further recommends that you don’t own a stock for 10 minutes unless you would be comfortable owning it for 10 years and lays out criteria where you can find a marvelous business at a discount to own through stock purchase.
Although the efficient market theory sounds rational the stock market is ruled by fear and greed so there are always irrational valuation if you know how to look, and remember you can get in and out of the market quickly and easily where the money managers cannot.
Also avoid Mutual funds unless you like to conservatively lose 60% of your money in fees over 40 years because of how compounding works (Payback Time – Phil Town). If you do not want to take the time to learn how to invest on your own and want to leave it up to the “experts” I agree with Brent use Index Funds, ETF, and I would add spyders.
It’s certainly not impossible to beat the market, just extremely difficult. Most individual investors that try fail miserably. If you really think you can do it I advise starting out with only a small portion of your investment money (5-10 percent) and tracking your results carefully and honestly. Compare your results to the market benchmarks and then decide if it is worth doing. The vast majority of investors will get better results with much less effort using low-cost index funds.
As I tried to explain in the last post unless a person approaches an investment as a business they are gambling not investing. For instance if a person wants to invest in stocks in what ever way they should approach each and ever decision by weighing the specific investment as if it is a business. Investing in index funds, mutual funds and so forth you are trusting a sales person to manage your money and they are ok as far as they go, but index funds are definitely superior.
If you want to invest in specific stocks however according to Phil Town you should invest based on the intrinsic value of the business or sticker price as he calls it not the stock price since the stock price is fickle and changes because of factors based on fear and greed. In his books Rule #1 and Pay back time he explains how to find the intrinsic value of any given business based on publicly available information about the performance of the business among other things. For example when buying a car a person can know the value of that car in what ever condition and determine what is a rational purchase price for it. The same is true of businesses. If you can find a wonderful business and buy it at a discount of its value through the purchase of its stock in the long run you will profit. As stated earlier only hold a stock for 10 min if you are comfortable owning it for 10 years.
Index funds are easier so long as a person is satisfied with returns that parallel the average return of all the stocks under management both when they go up and down, and the understanding that you will pay the fees regardless of results.
Education is more difficult and time consuming with the potential but not the guarantee for better returns. Our biggest advantage is that we are more nimble than the fund managers and access to all the pertinent information for making an informed decision that they have.
You are absolutely right that you need to watch out for costs. However, the fees I pay for investing in index funds and ETFs are extremely low. Far less than most people pay investing for themselves. I will write more about investment costs in the future.