Beat the Market? Not Likely: Why Outperforming the Average Investor is a Challenge

The quest to beat the market is a common goal for many investors. However, as highlighted in the "Beat the Market? Not Likely" section, it's a surprisingly difficult task, even for those who manage mutual funds full-time. This article explores the challenges of outperforming the market and provides some insights for investors.

 

The Difficulty of Beating the Market

• Most professional fund managers fail to beat the market. Data from SPIVA scorecards, which compare the performance of actively managed stock and bond funds against their benchmark indexes, reveals that a majority of fund managers cannot outperform the market. The most recent scorecard showed that more than three-fourths of all U.S. stock funds (76.2%) failed to beat the S&P 1500 Composite index over the previous 12 months. Over the long term, the numbers are even worse; over 10 years, 90.1% of the funds underperformed the benchmark.
• Even in down years, active funds struggle to outperform. From 2010 to 2024, large-capitalization domestic equity funds failed to beat their benchmark, the S&P 500, every year, even in years when the index declined.
• Past performance is not indicative of future results. Even if a manager outperforms one year, there's no guarantee that success will continue. Only a very small percentage (2%) of funds in the top half of their categories remained there over a five-year period.

 

The Case for Index Funds

• Warren Buffett's Bet: In 2007, Warren Buffett bet that a low-cost S&P 500 index fund would beat a group of actively managed hedge funds. Over the decade, the index fund returned an average of 8.5% annually, while the hedge funds returned only 3%.
• High fees of active management: Hedge funds charge high fees (typically 2% of assets annually plus 20% of gains) while index funds have very low fees. For instance, an S&P 500 tracker like SPDR S&P 500 ETF Trust (SPY) charges only 0.095% of assets.
• Efficient markets: Today’s stock and bond prices reflect all the information that can be known about those entities today, so tomorrow's prices are essentially a "random walk".

 

Why People Still Choose Active Investing

• Undervalued Stocks and Funds: While the market itself is efficient, some believe individual stocks and funds may be undervalued. Small-cap stocks may be less efficient.
• Intellectual and emotional satisfaction: Investing can be an enjoyable endeavor; buying and selling stocks allows investors to exercise their own judgment.

 

Strategies for Investors

• Consider index funds: Given the difficulty of beating the market, consider investing in low-cost index funds that track the overall market.
• Look at small-cap funds: Small-cap stocks tend to be a less efficient category where it may be easier for active management to generate alpha.
• Value is important: Investors should be wary of very high valuations, as eventually, valuations do matter. Overvalued stocks and portfolios are at risk for substantial corrections. As Warren Buffet has said "Performance comes, performance goes. Fees never falter".
• Do your research: If selecting actively managed funds, look for funds with a history of consistent performance and those that have done well over multiple time periods.
• Be wary of trends: Avoid speculative stocks, almost anything associated with artificial intelligence. These stocks may be overvalued and may have a difficult time living up to the hype.
• Stay defensive: Select more defensive sectors and more reasonably priced individual companies and have a comfortable cash reserve.

While the idea of beating the market is appealing, the data suggests it's a difficult task, even for professionals. The most important thing for an investor to do is to make a plan and stick with it.