You Can’t Beat the Market and You Should Stop Trying

Here are some common questions I get asked as a financial adviser. What’s your system? What’s your investment strategy? Do you focus on market timing or relative value? How do you plan to outperform the market?

These questions are natural. Investors want to understand what advisers are doing with their money. But in a way, these questions demonstrate a lot of the misconceptions about what exactly counts as success in retirement saving.

You shouldn’t try to beat the market. Instead, investors should actually aspire to equaling the market return. Let’s take a look at why.

Earlier this year, in my post about confirmation bias, I noted that even though U.S. stocks have historically returned 7% to 8% to investors, and bonds and commodities have returned 3% to 6%, the average investor has only earned a little over 2%. Why do investors perform so poorly?

Why do investors underperform?

There are three main reasons why the average investor earns returns that are nowhere close to an average market return.

1. Investors make emotional errors during market swings, over-investing at market peaks and running away during lulls.
2. Investors make cognitive errors that cause them to overestimate their own competence and performance.
3. Investors pay active fund managers fees that are too high.

Stop trying to beat the market

Today I’d like to focus on #3, and why I don’t think investors should ever pay an adviser to try and beat the market.

Let’s start with some simple definitions. We’ll be discussing passive money managers and active money managers. Active money managers take investor money and try to invest it in a way that outperforms the overall market return. For example, an active money manager that uses the Dow Jones Industrial Average stock index (the “Dow”) as a benchmark might try to earn an 8% annual return in a year where the Dow overall earned a 7% annual return, in which case that manager will be said to have outperformed their market by 1%.

In contrast, a passive manager simply attempts to replicate their benchmark return. In the above case, a passive manager would invest in a basket of securities designed to match the Dow’s 7% annual return as closely as possible. In exchange for their humbler goal, passive managers typically charge much lower fees than active managers.

Example 1: Fees destroy any potential value creation for the average investor

By definition, the “Market” return is equal to the dollar-weighted average return of each active investor in the marketplace. The market, after all, is just the aggregated actions of all of the individual active investors. A consequence of this simple algebra, is that exactly half of “active” money performs worse than the average market return.

But it gets worse. Active managers aren’t volunteers. They charge a fee for their active management. So, for the “good” half of active managers who are successfully beating the market, there are still a bunch that aren’t beating the market by enough to pay back their own fees.

For example, if the market return is 8%, an active manager that earned a 9% return on your investment might brag about that. But if that manager charged a 1.5% annual fee for their expertise, you only realized a 7.5% return on your money and you actually underperformed the market by 0.5%.

So unless you have good reason to believe you have a really exceptional ability to discern which are the best active investors, you should expect to underperform the market by a few percentage points with an active money manager.

But it gets even worse!

Example 2: Selecting an active manager is a futile exercise. In many cases you will not even be able to access a good active investor

Consider the following imaginary universe. There are 100 investors and 10 active fund managers. Each investor has $1,000 to invest and can choose to invest their money with any of the active managers, for a total market size of $100,000.

Let’s say each adviser earns 1% of year-end “Assets Under Management” (AUM) as a management fee and 10% of client gains as a performance fee. We’ll look at how the investment landscape shifts over two full years.

Year 1:

At the beginning each investor randomly picks an adviser so everything ends up split evenly. Each adviser has 10 clients with $1,000 each, giving each adviser an AUM of $10,000 per adviser. Now let’s look at how each adviser performs in Year 1:

• 1 adviser stinks and loses half of client money
• 4 advisers are bad and earn a 5% annual return
• 4 advisers are good and earn a 15% annual return
• 1 adviser is a genius and earns a 210% return

What does this mean for fees?

• Adviser 1 earns $50 as a management fee, and no performance fee
• Advisers 2-5 earn $105 as a management fee, and a $50 performance fee
• Advisers 6-9 earn $115 as a management fee, and a $150 performance fee
• Genius earns $310 as a management fee, and a $2,100 performance fee

In other words, the best active advisers are the ones that are least likely to be discovered by prospective investors.

Before Year 2:

OK, so now what happens at the end of Year 1? Ten clients run away from Adviser 1, screaming bloody murder. Ten or twenty of the clients for Advisers 2-5 would probably leave their adviser too. They would have heard about Genius’s cool new investment strategy and would ask Genius if she is still accepting investor money. It appears that Genius has found a reliable strategy for beating the market that other investors haven’t discovered yet, so she is in high demand now.

So now Genius has $50,000 under management or so. $31,000 of prior client money, $5,000 from the bruised investors that used to be with Adviser 1, and let’s say $14,000 that came over from Advisers 2 through 5. What happens next?

Year 2:

Let’s assume adviser performance is the same as last year.

• Advisers 2-5 earn mostly the same fees as before, just a little less due to the lost clients
• Advisers 6-9 earn mostly the same $250-$300 in fees as last year
• Genius now has $50,000 to invest and turns it into $155,000 for her clients. That gives her a $1,550 management fee and a $10,500 performance fee

Something weird happens at the end of Year 2:

Note what happens here!! Genius Adviser now has $14,460 of her own money she has built up from all those fees. This is over ten times more than what any client started off investing in Year 1. Because of her superior investing skill, Genius Adviser is now a whale of an investor in her own regard. In fact, she is the largest investor in our tiny universe. Her strategy works, and she is earning crazy money for herself and her clients.

But put yourself in Genius Adviser’s shoes. During an average week in the upcoming Year 3, would she rather spend time:

1. soliciting and onboarding new clients to increase management fees, or
2. perfecting the strategy and finding new ways to implement it for herself and existing clients

The correct answer is #2. Because Genius Adviser has so much of her own money invested in her own system, she now no longer needs or wants to ask for fresh money. She’s just going to want to keep the clients she has and keep doing what’s working. This is precisely the situation for a lot of real-world top-performing hedge funds.

This situation is bad for new investors

This is a problem if you live in this tiny little universe and have just decided to become investor number 101. If you start googling for “money managers”, you’re only going to get responses from Advisers 1 through 9. And Crappy Adviser 1 might even send you some paid ads because his business has tanked so badly that he needs new clients.

So as a new investor, your situation is actually much worse than our earlier observation that half of active investors will underperform the market. If you limit your search space to advisers that are actually willing to talk to you, your odds of outperforming the market are much, much worse than 50-50.

In other words, the best active advisers are the ones that are least likely to be discovered by prospective investors.

So what should you do instead?

The simple answer is that you should invest your money passively with funds and advisers that charge low fees and strive to earn an average market return. Like me!

If you can earn an average market return, with low fees, and a sensible tax strategy, you will be doing much better than most other individual investors. I’d happily suggest looking at Luther Wealth for exactly that!

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