In many areas of life, making decisions based on all the evidence available is critical, such as in medicine and law. When it comes to investing, however, people are often unaware of the overwhelming evidence that could inform their choices.
Typically we are brought up to believe that winning is best, that beating the competition is our objective. So it makes sense that investors are inclined to draw confidence from those who tell them they can beat the market, despite compelling Nobel Prize-winning evidence to the contrary.
To be clear, ‘active’ funds attempt to beat the market with portfolios compiled by professional managers based on their stock-picking skills. ‘Passive’ funds seek to deliver market returns by tracking indices representing the global markets.
According to Robin Powell, award-winning journalist and campaigner for positive change in global investing, “active asset management has been found out. It’s a confidence trick that adds little or no value for consumers.”
Why is this the case?
Markets combine the knowledge of all investors to arrive at a price
Simply put, together we know more than we do alone. One of the most cited examples of the Wisdom of Crowds involves a group’s collective ability to accurately guess the number of jelly beans in a jar.
For each individual, predicting the number of jelly beans is very hard. People do their best to estimate, but it’s not surprising that most are way off. What is surprising is that when you have a large enough group, the average answer tends to be highly accurate – even more accurate than the best guesser in the group.
This happens because, for every person who wildly overestimates the number of beans, there is another person who wildly underestimates. And if you have a large enough population, you get an equilibrium of opinion around what usually turns out to be a very accurate number.
This theory was tested in 2013; the guesses ranged from 409 to 5,365. The correct answer was 1,670 with the average of the guesses being 1,653. Incredibly close to the correct answer. By accepting that the view of the market is correct, you’re harnessing the knowledge of those creating £347 billion of trades each day.
Source: Dimensional Investing
Thanks in part to the evolution of computers that allow vast amounts of information to be processed, the field of finance has undergone a transformation over the last three decades. Some of the brightest academic minds have produced ground-breaking research, treading new paths in applying these insights to real-world investing.
A total of four Nobel Prizes in economic sciences have been awarded for this work between 1990 and, most recently, 2013.
The corresponding Efficient Market Theory takes the jelly bean example one step further, believing that because prices are the combined knowledge of millions of investors, those prices will reflect all publicly available information that impacts an investment’s expected risk and return.
This means market prices provide our best estimate of the value of an asset. Attempting to outguess the market is not a reliable way to improve returns.
If successful, it should be acknowledged that luck has had a part to play. If enough guesses are made, a few of them are bound to be right – even a broken clock is right twice a day!
Higher costs of active management
Beating the market is difficult. Beating the market consistently is even harder. According to data reported by AEI, a public policy think tank “it’s really hard to ‘beat the market’ over time, 95% of finance professionals can’t do it.” This was over a 15-year period.
Fund managers find it nearly impossible to deliver you high returns consistently, but that’s not the only problem. Fund managers have to recover their costs through performance, just to break even. Unfortunately, because of the high fees many charge, the chances of your portfolio outperforming the market, and leaving more money in your pocket, are further reduced.
We’re conditioned to believe that we get what we pay for; that expensive must be good. But applying this theory to your investments won’t guarantee better returns.
Passive investment funds have the benefit of capturing the market return at a very low cost. We’ll be bringing you more on the impact the cost of investing has for you in a future edition of The Big PictureTM.
Beyond the theory
What makes the case against the value of active investing stronger still, is that even investing legends such as Ray Dalio and Warren Buffett tell you to invest in the market and let it do the work for you.
The most successful investors ensure the odds are stacked on their side, and the odds of beating the market are incredibly low. So why add the additional risk and cost to your life savings by doing so?
The chart below shows the outcome, across several different markets, if you had simply invested £1 back in 1989. As you would expect, the lower risk markets have provided a lower return than the higher risk markets over the 30 years, but all the equity markets have provided extremely strong positive returns.
Source: Dimensional Investing
As Warren Buffett, one of the world’s most successful investors, once pointed out, “No consultant in the world is going to tell you: ‘Just buy an index fund and sit for the next 50 years.’”
We often see the complex as more believable, but it is the simple solution, buying and holding a diversified portfolio that represents the global markets, that will win out over time. This is the more sophisticated approach to investing.
A safe pair of hands
Rather than active management acting as a safe pair of hands, it’s asking an individual, or at most an individual and their team, to identify the investment opportunity that billions of other investors have missed, as this is how they beat the market.
Evidence shows us that high returns produced by those who appear to be ‘star’ fund managers are more likely to be driven by a run of luck than skill.
As the manager’s perceived ‘star status’ rises, they attract more and more money from new investors, but we’ve seen this go wrong. Just last year, fund manager Neil Woodford suspended trading in his UK Equity Fund – this despite him having ‘star status,’ gained during an illustrious 25-year career.
The impact for the 300,000 investors that have had their money locked in and falling in value since June has been devastating.
The Life Matters approach
Rather than buying and selling assets to try and beat the market, we harness the power of science to build low cost, well-diversified portfolios that allow you to prosper in any environment, maximising the chances of a successful investment outcome.
Furthermore, this approach provides an opportunity to beat the market, without having to outguess it. More to follow on this over the coming months.
Get in touch
If you’d like a second opinion on your current investments with no obligation or cost to you, please get in touch. Email your@lifemattersfp.flywheelstaging.com or call 01202 025481 to find out more.
Please note
The value of your investment can go down as well as up and you may not get back the full amount you invested. Past performance is not a reliable indicator of future performance.