Can Individuals Beat the Pros?

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© Brendan Ross

We’ve seen clear evidence in other articles that mutual funds are bad at managing your money.  Not only do most lose versus index funds, but the winners don’t tend to repeat, instead dropping randomly back down the ranks. (Active vs Index Investing, Efficient Markets, Predicting Mutual Fund Performance)

Mutual fund managers get paid every year

Whether they do well or poorly for you, the mutual fund managers do great for themselves, paying themselves from fund assets irrespective of fund performance.

The difficulty for individual investors trying to beat these professionals is two-fold:

  1. You do not have the time, experience, or relationships to match professional money managers
  2. You’re risking your own money, so you don’t get to draw a salary from other people’s money during a bad year (or a bad decade).

If you can’t beat a pro athlete, how can you beat the markets?

Very few people believe that they could take the field and compete with professional athletes.  Very few believe they’d be as good in front of the Supreme Court as a polished career attorney.  Yet the nation’s wealthy suburbs are filled with people who ARE CONVINCED  that they can beat the markets.  Why?

Advertising is profitable for advertisers, not for investors

The key phrase here is “are convinced”, because that is exactly what is happening.  A Google search for “stock market newsletter” returns 389,000 results.  The right side of the search return, with sponsored links, has over 175 paying advertisers.  All of them have found a way to turn your clicks into profit.

Think of the TV shows, radio programs, magazines, and websites that all push stock ideas.  We’re bombarded by financial advice,  much of it identifying hot stocks, hot sectors, and hot ideas.  The overall message is one of empowerment.  YOU can capture GREAT WEALTH, but you have to ACT FAST.

A surprising message from Mad Money’s Jim Cramer

This noise does not exist to serve investors, it exists to serve advertisers.  Media companies sell your eyeballs to advertisers, and stories on index funds are boring.  Can you imagine an episode of Mad Money devoted to the tax consequences of active management vs index investing?   Yet Mad Money host Jim Cramer had this to say in his book, Stay Mad for Life:

“Invest in index funds or the lowest-cost mutual funds offered by your 401(k) plan. …it’s the advice that most people fail to take. People always want to know which mutual fund will give them the best return, but it turns out that’s a bad question. Even before you add up the fees, actively managed funds fail to beat the market 80 percent to 90 percent of the time. That means that at least in your 401(k), you’re better off investing in an index fund with low costs that simply tries to mimic the performance of the entire market than in a mutual fund that tries to beat the market.”

Why isn’t this a repeated theme on his show?  That this is hypocrisy on Jim Cramer’s part does not detract from the wisdom of his advice.  I’m not sure why Jim limits his good advice to 401(k) plans, especially given that taxable investments are the worst sort to be managed actively (RAA article on taxes).  Perhaps Jim felt uncomfortable telling people in one paragraph to ignore the rest of his book and the content of his show.

How pension funds choose money managers

There are a number of large, well-reputed organizations that help pension funds search for money managers.  One of these, Russell, has a process that it touts on its website.  Here’s what they say:

“Manager research and selection have been Russell’s core competency for decades. We do the research for you by meeting face-to-face and monitoring thousands of managers around the world. We analyze factors that go far beyond performance to help determine a money manager’s ability to produce consistent, long-term results.”

Funnel showing the few managers who are chosen to manage funds

Let’s see how Russell did versus the S&P 500:

Russell actively managed fund loses to the Vanguard index fund over 10 years

After all of the enormous effort that Russell put forth for its own investors, the fund fell short of a simple Index fund both before and after taxes.

Wealth managers choose indexing

As mentioned in the main essay, Active vs Index Investing, pension fund managers are rapidly moving to index investing.

So, mutual fund managers are demonstrably unable to beat the markets.  Pension fund managers are migrating billions into index investing.  More and more, it’s individual investors who are left paying Wall Street’s salaries.

Stock newsletters are written by charlatans

As for the legions of newsletter writers purporting to have hot stock tips, if they were anything but charlatans they would have jobs as pension fund or mutual fund managers.   Salaries for mutual fund managers average $350K and range up to $2 million.

CNBC is unlikely to have good advice for you

Remember that there are between 200,000 and 1,000,000 people actively trading stocks at any given time.  This group very rapidly incorporates new knowledge into equity pricing.   If you are given information, say on CNBC, that a particular stock is under-priced, then you have to be aware that this opinion flies in the face of the entire investing community, which has settled on the current price.  For you to be right, legions of analysts and other investors have to be wrong.  This is unlikely.

Don’t be tempted into thinking you will beat the markets

Individual investors are tempted to think they can do what professional money managers cannot:  beat the markets.  RAA’s message to investors is to think this through very carefully, since your ability to retire may depend on your accurately judging your own abilities.

A little speculation is OK - if you must

On a final note, investors with a tremendous love of the markets need not divorce themselves entirely from the game.  We are happy to safely manage 90% or 95% of your wealth, leaving you a reasonable base from which to speculate.   This is not unlike most people’s Vegas strategy:  bring the money you can afford to lose.    No sense in playing with all of your marbles.