How to beat the market

28 July 2017
Closeup of Paul's head

Well, that got your attention, didn’t it? You are in good company. A quick search of “Beat the market” under the books section of yields 951 results. So clearly, this is a topic of interest to many people.

I suppose the first question to ask is if it is even possible to beat the market. We are used to thinking that innate ability, education, training and experience can combine to produce competence at a certain activity. A nimble rugby player scores more tries and an experienced car mechanic is more likely to fix your car. We conceive of a world in which we can identify competence, and for the right price, acquire it.

So can you beat the market? Of course you can – if you are moderately lucky. After all, simple arithmetic dictates that roughly half of all investments will turn out to be winners relative to the average. So simply showing that some people have managed to beat the market is not, in itself, evidence of an ability to beat the market. What we really want to know is whether it is possible to beat the market without relying on luck.

The academic community has had a century or so to consider the question. Prior to the 1960s it was thought that investing was a skill which could be both taught and applied in practice to produce market-beating returns. Then along came the Efficient Market Hypothesis (or EMH as it is known in academia). The EMH states that in a perfectly efficient market it is impossible to beat the market by more than one would expect if it were purely a matter of luck. Empirical evidence appears to support the EMH. Studies have repeatedly shown that actively managed funds under-perform the market on average.

That brings us to the current received wisdom. Markets are efficient and, for most people, it is not worth the trouble to try to beat the market. Instead, investors should simply ‘buy the whole market’. Invest in a fund that passively tracks a broadly diversified index. Since a passively managed fund does not need to pay the salaries of an army of highly qualified and expensive analysts and managers, the fees are much lower. Investors appear to be taking heed of this advice, as funds continue to flow out of active fund managers and into passively managed index-tracking funds.

All of this seems to reflect badly on active fund managers. If they can’t even beat the market, perhaps they are not trying very hard? Not necessarily. Paradoxically, the collective inability of active fund managers to beat the market is exactly what one would expect to see if there were a large number of talented individuals trying their very best to beat the market. It is because active investors are trying so hard to exploit profitable trading opportunities that collectively they fail to beat the market.

In my opinion, investing in a broad-based passive index-tracking fund remains a sound starting point for most investors today. However, it might not remain good advice forever. As a thought experiment, suppose that money continues to flow from active fund managers to passive index tracking funds. That means fewer analysts poring over verbose regulatory filings, fewer economists trying to understand drivers of growth and fewer managers trying to eke out another few basis points from their portfolios. At some point, the reduction in talent hunting for profitable investments (inefficiencies) will start to reduce the overall efficiency of the market. Are we there yet? Probably not. However, if current trends continue, we may well find ourselves in a world were mispricing becomes a lot more common. If mispricing becomes big and widespread enough, active investing becomes a far more attractive option relative to passive investing.

The debate is no longer about whether markets are efficient or not. Few people who have spent significant time on a trading floor believe that markets are perfectly efficient. Evidence to the contrary is all around them. Mistakes happen, people have bad days, markets panic, bosses make arbitrary calls, clever trading algorithms turn out not to be so clever after all. The current view in academia is that market efficiency is a matter of degree, not a true/ false question. There exists, if you like, an equilibrium level of mispricing or inefficiency. If markets are reasonably efficient, then investing passively is a good starting point for most of us. But markets can only be reasonably efficient if at least some investors are actively trying to beat the market. Even though passive investing is a good starting point, active investing still has a place in the market.

Dr Paul Geertsema is a member of the Department of Accounting and Finance, part of the University of Auckland's Business School.

Reproduced with permission from the National Business Review (NBR) How to beat the market, published Friday 28 July 2017.