THE WALL STREET SELF-DEFENSE MANUAL

7: Meet Your Competition

If you are like most investors, your reaction to the idea that most active investors lose will be, “So what?  The odds are against success in many endeavors in life, and winners still win.”  If this is your attitude, you will get nothing but encouragement from Wall Street.  The “you can beat the market” story is not only extremely profitable for those who make a living by facilitating active management.  It is also a story you want to hear—you’re a winner!—and one that plays to your ego and the American dream of independence and self-sufficiency.

 

Your odds of winning the active management game are lousy.  But, still, you have a point.  The odds are also against building a successful company, opening a successful restaurant, or writing a best-selling novel—and this doesn’t (and shouldn’t) stop you from trying.  So if, after reviewing the evidence, you really believe that you can consistently outwit most investors, then try.  Better yet, go into the money management business, where you can make a fortune even if you fail.  Whatever you do, don’t buy the hogwash that beating the market is just a matter of reading some research, analyzing some financial statements, and picking stocks or funds in your spare time.

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To win the active management game, you have to consistently outsmart the vast majority of other investors.  Your relative skill, therefore, matters.  In this way, active management is actually different from most games in Las Vegas--craps, blackjack, roulette—in which your odds are always negative.  A better analogy for active management is poker.  In poker, the overall odds for the table are negative (because the house takes a cut of every pot), but the odds for the best players at the table are positive.  In poker, you can win if you are only average, as long as the other folks at the table stink.  An intelligent poker player, therefore, need not be confident that she is world class—just that she is better than the people she is playing against.

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Unfortunately, this is where the analogy ends.  In the global financial markets, there are no special tables for beginners, hobbyists, and suckers.  There is just one table, and, every time you sit down at it, you will be competing against the best players in the world.  True, you will also be competing with tens of thousands of boneheads.  But the majority of your competitors will be smart, experienced, well-trained, well-informed professionals who do little but play the game.[1]

 

Is it possible for you to beat these players consistently?  Yes.  Is it likely?  No.

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Your Competition

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If you play the active management game, your competitors will be all other active investors—including many who read the same research, use the same trading tools and services, and listen to the same experts as you do.  Most of these competitors will be full-time investment professionals with resources, contacts, information, and experience that you can only dream of.  These competitors will be working around the clock—and around the globe—seven days a week, with only one goal in mind: to kick your ass.

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Why?  Because that’s the only way they can win.  Remember that active management is a zero-sum game: Every above-market return earned by one investor must come at the expense of another.  For you to beat the market, you must consistently beat most of your competitors.  So it behooves you to have a good grasp of who they are.

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Your competitors include thousands of professionals employed at mutual funds, hedge funds, pension funds, trusts, banks, trading desks, brokerage firms, governments, and corporations who collectively manage tens of trillions of dollars worth of money worldwide, as well as millions of small investors who manage trillions more.  Do not delude yourself into thinking that, because there are more individual investors than institutional investors, you are competing against amateurs.  Professional investors manage the vast majority of money and conduct the vast majority of trades.  According to Charles Ellis, author of Winning the Loser’s Game, more than 90% of the trades on the New York Stock Exchange are made by professionals.  Chances are high, therefore, that the person buying from you or selling to you knows what he or she is doing.

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The skill and sophistication of your competitors varies, but, on the professional side, even the average ones have enormous resources.  For example, the average professional:

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• researches investments for at least ten hours a day.
• has access to every news story, blog, press release, financial filing, and company presentation ever published, as well as off-the-record commentary that is often far more revealing.
• spends thousands of dollars a month on primary research.
• has relationships with professional analysts at dozens of firms.
• visits dozens of companies a year.
• participates in hundreds of conference calls and investment conferences a year.
• has a Rolodex full of industry sources.
• has years of full-time money management experience.
• gets every Wall Street research report in seconds.
• gets daily calls from salespeople at thirty-odd Wall Street firms relaying every scrap of information, scuttlebutt, or rumor they hear.
• has phone numbers of CEOs, CFOs, etc., on his or her cell phone.
• and, yes, watches CNBC (often howling with laughter).

Are these professionals so talented and well-informed that they can’t be beaten?  No.  In fact, despite these advantages, more than half lose the active management game—usually to other professionals.  The efforts of all these professionals do, however, make it harder for you to win, a fact that you would be wise to keep in mind.

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Those who have a vested interest in your trading often imply that the reason most professionals lag the market because is that they are incompetent (implication: you can do better).  Sadly, this is absurd.  It is similar to suggesting that major league baseball players strike out a lot because they are incompetent.  Professional baseball players are not incompetent, and unless you’re willing to do the work necessary to become one, you almost certainly can’t do better.

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Three Advantages You Do Have

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Some good news:  If you invest intelligently, you will have three potential advantages over most professionals.  The first will effortlessly allow you to beat the majority of them.  The second and third might even, in rare cases, allow you to beat the market.

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Your first advantage—the only one you should embrace unless you are willing to devote your life to the task—is that you don’t have to try to beat the market.  Instead, you can just buy low-cost passive funds.  This will guarantee that you will beat most professionals, who are paid to try to beat the market and, therefore, can’t buy low-cost passive funds.  The most client-oriented move for most investment professionals would be to fire themselves and put their clients in index funds.  Few will choose this route.

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Does buying low-cost index funds sound like a cop-out?  Well, here’s another way of saying the same thing:  After more than a century of research, the world’s smartest investment gurus have finally figured out a simple, foolproof way for you to beat the pros.  You don’t need expertise.  You don’t need to spend time or money learning complex techniques.  You don’t have to buy software, hire advisors, or read research.  You don’t have to worry about making expensive mistakes.  You don’t have to read a single annual report, make a single forecast, or talk to a single customer or employee. The secret?  I could tell you, but then Wall Street would have to kill me.

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Your second advantage is size.  For two reasons, managing a small amount of money is often easier than managing a big one: You have more securities from which to choose, and your transactions will not move the market.  The manager of a massive equity fund must restrict purchases to large stocks, because small ones aren’t big enough to amount to a meaningful position of the portfolio.  Trading large blocks of stock, meanwhile, usually has an adverse impact on the price of the stock, thus reducing a fund’s return.  Small investors, in contrast, can buy or sell any stock in the market, and their transactions do not usually affect the price.

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Your third advantage is that, unlike most professionals, you do not have to answer to impatient, demanding clients and, therefore, do not have to focus on absurdly short time frames.  The investment business has become so competitive that managers are now held accountable for performance over weeks, months, and quarters.  A manager who under-performs over these periods will quickly get flak, and, if the under-performance continues, will soon get fired.  The relentless focus on short term performance forces managers to balance investment risk with business and career risk, and, in so doing, make low-percentage, short-term bets.  This behavior often reduce the manager’s odds of beating the market over the long term, and also generate increased transaction, research, and tax costs (thus hurting the client two ways).  The reality of the money management business, however, is that most clients focus on short-term performance, so most professionals must focus on short-term performance, or else risk damaging their businesses and careers.  You, on the other hand, have the luxury of being able to focus on the long term.

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A long-term focus lets you take factors like valuation and mean reversion into account.  Over short time frames, valuation—a stock’s price relative to the underlying company’s cash flows—has little impact on what the stock will do.  Over the long term, however, valuation matters.  Focusing on the long-term also allows you to reduce costs and stop worrying about what the market will do next (anyone’s guess).  It allows you to capitalize on opportunities created by the short-term behavior of most investors: You can buy cheap stocks that might take years to move, or sell expensive ones that might continue to soar for a while.  Just as important, it allows you to avoid competing with most professional investors by playing a different game—the one, not coincidentally, Warren Buffett plays.[2]    E

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Even with this advantage, beating the market will be hard enough that you would almost certainly be better off buying a passive fund.  But you will have a better chance than if you try to out-trade SAC Capital, Soros Fund Management, Fidelity, et al.

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So, yes, it is possible to consistently beat professional investors.  It is unlikely and difficult, however.  Most professional investors are not stupid or incompetent.  And, believe me, they will be very happy to compete against you.

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[1] Lest the poker analogy make you think that you just have to be better than most investors, Dartmouth professor Kenneth French adds a further insight.  If you sit down at a poker table at which you are better than five of the seven players, do you think the best two players, the ones who are better than all six of you, are happy or sad that you showed up?  Happy.  Your playing just means more money for them to win.

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[2] In part because Warren Buffett is CEO of his company, in part because he is not an employee at a mutual fund, and in part because is extraordinarily clear-headed, Buffett takes a longer-term perspective than most institutional investors.  This does not make him immune from bouts of crappy relative performance, or the criticism, frustration, and ridicule that inevitably accompany them.  It just means that he is less exposed to the career and business risk than many professionals.

6: So, Just Beat The Market!

Confronted with the depressing facts about real market returns, the natural reaction is to say, “Well, then I’ll just beat the market.”  How will you do this?  You’ll buy winners and sell dogs.  How will you do that?  You’ll find a crackerjack broker to funnel you a steady stream of “tips”—or you’ll just watch CNBC, scour financial statements, and do it yourself. 

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And maybe you will.  Half a century of performance data suggests that a handful of investors with exceptional dedication, information, and skill can indeed pick stocks well enough to beat the averages over the long term (many do it over the short term, but this is usually the result of luck or the vicissitudes of investment style, not skill).  If you truly dedicate yourself to the task, therefore, you might succeed.

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The same half-century of evidence, however, suggests that you almost certainly won’t.  Instead, like most investors, including professionals, you will probably just waste money and time.  Importantly, if you do fail to beat the market, it will not be because you are incompetent or stupid.  One dangerous misconception about investing is that the reason most investors lag the market is that they are morons.  The real reason is that beating the market is hard.  (Another dangerous misconception is that intelligent investors should try to beat the market.  On the contrary, most should begrudgingly accept the market return.)

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Before continuing, we need to step back a bit, because if your friends or advisors haven’t seen the light on this, they will bludgeon you with a thousand examples of funds that have “beaten the market” over such-and-such a period.  They will also probably announce that they routinely beat the market.  And in the name of Wall Street self-defense, you need to know why they are usually wrong

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Active vs. Passive Management.

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Most investment strategies fall into one of two camps: Those that try to beat the market (or subset of a market called an index) and those that don’t.  The former, called “active” strategies, employ a variety of techniques—stock picking, market timing, fund picking, sector picking—to try to beat the averages.  “Passive” strategies, meanwhile, buy and hold all (or a representative sample) of the securities in an index, regardless of market conditions, with the aim of capturing the market or index return. 

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Importantly, passive investing does not just mean buying an S&P 500 index fund.  Markets can be segmented into dozens of indices, and passive strategies can be designed to track any of them.  Some of these indices, moreover, screen stocks by size, book value, earnings, price, and other fundamental metrics that most investors associate with traditional stock-picking techniques.  As passive investing has become more refined, in other words, the distinction between active and passive has become less clear-cut.  At the most basic level, however, an active investor will try to “pick winners,” while a passive investor will just aim to capture an index return.

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Most investors are active investors.  Why?  Because, at first blush, active management seems by far the superior strategy.  Who wouldn’t want to own just winners?  Who wouldn’t want to dump dogs?  Who wouldn’t want to get out before market crashes and in before market booms?  Who wouldn’t want to own a fund managed by “the next Warren Buffett”?  Answer?  No one.  As a result, most investors (or their advisors and fund managers) trade incessantly, with the aim of producing an above-market return.

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Not all active investors realize that they are trying to beat the market.  Some think they are just “investing.”  The only reason to practice active management, however—the only reason to pick stocks, time the market, buy actively managed funds, etc.—is to try to beat the market.  There was a time when advisors and fund managers could imagine that their job was to merely help clients “make sound investments,” but that time is gone.  The proliferation of low-cost index funds, life cycle funds, and other passive vehicles has made it easy and cheap for any investor to get near-market returns.  Anyone who chooses an active strategy over a passive one, therefore, is—knowingly or unknowingly—trying to beat the market

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What “Beating the Market” Means

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Any intelligent discussion about beating the market has to start with a definition of what the phrase means.  One popular definition is “beating the S&P 500,” a broad index of large US stocks.  For some investors, the S&P 500 is a meaningful benchmark with which to evaluate portfolio performance.  For others, however—such as those who trade small stocks—it is not.  Even when the S&P 500 is the appropriate benchmark, moreover, comparing relative performance is only meaningful when one also considers relative risk.

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For an investment to be worth making, it must have an expected return that compensates for its risk.  A stock that offers the expected return of a Treasury bill would be a bad investment.  (Just buy the safer Treasury bill.)  A Treasury bond that paid real interest of 7% per year, meanwhile, would be a great investment (equity-like returns with lower risk).  Thus, for an investor benchmarked against the S&P 500, the relevant question is not just “Did she beat the S&P” but “Did she beat the S&P while taking the same or less risk?”  Similarly, a better definition of “beating the market” is either: 1) generating a better risk-adjusted return than an index by picking winners, or 2) generating the index return with lower risk

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Welcome to a Zero-Sum Game

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The most important thing you need to know about trying to beat the market is that, unless you possess truly superior skill, the odds are against you.  If, like most people, you have made money in the markets, this is hard to accept.  It is true, however.  In aggregate, active-management returns will lag market returns, and the average active investor will lose.

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Judging by the number of commentators who express surprise, dismay, and/or scorn about manifestations of this sad fact—such as the observation that most professional fund managers fail to beat index funds—it is not widely understood.  It is therefore worthy of a detailed explanation.  There are two reasons why active management returns will always lag market (and low-cost passive) returns.  First, the aggregate gross return of all investors who trade within a market must equal the return of the market.  Second, active investors incur return-reducing costs that the market does not.[1]  

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This does not mean that the market can’t be beaten.  Each year, about half of the stocks in the market usually beat the market, and active managers who own more of these stocks than laggard stocks beat the market. (Whether they do this because of skill or luck is a different question, as is whether they will beat the market again next year.)  What it does mean is that, taken together, the performance of all active managers can be no better than the market return.  It also means that, after their costs are deducted, again in aggregate, active investors will do worse than the market return. (For a detailed example, please see the Notes.) 

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Before fees and costs are considered, in other words, active management is a zero-sum game.  After fees and costs are deducted, moreover, active management is less than a zero-sum game.  Specifically, it is a game in which the expected outcome is negative, in which the odds are against the average participant winning.  While some active managers will win, the majority will lose[2].

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[1] Nobel Prize winner William Sharpe explains why in a short essay called “The Arithmetic of Active Management.”  The gross return of a passive benchmark containing every stock in a market must equal the gross return of all active funds trading the stocks in the market.  If it does not, the sum of the passive returns plus the active returns would exceed the market return.  Because active funds have expenses, moreover, and the passive benchmark does not, the collective return of the active funds will always be lower than that of the benchmark.  The only way that active mutual funds can, in aggregate, beat passive benchmarks is if there is another group of traders who are much less skilled than active fund managers (for example, individual day traders).  If the day traders do badly enough, the mutual funds might, in aggregate, do better than the passive benchmark.  On a gross basis, however, the return of all actively managed money cannot exceed that of the market as a whole. 

[2] Strictly speaking, it is the average actively managed dollar that must lose, not the average active manager. Because a handful of investors—the top 200 institutional managers—control a large percentage of actively managed dollars, it is conceivable that a majority of investors could win, even though the majority of actively managed dollars lost.  For this to happen, however, the top 200 institutions would have to perform worse than all other investors—a scenario that, given their awesome research and trading resources, experience, and skill, seems unlikely.