YOU Cannot Beat the Market. So STOP Trying!

You’ve all heard it before. And you’ve heard it a lot from your friends and family: “I’ve got this great stock tip. You should get in on it.” It’s the oldest story and the best one to tell. It’s the story of the American Dream. You find some mispriced security that the market has overlooked, you bet heavily on it, and lo and behold, you have your yacht, or your mansion, or whatever it is that your vision of the American Dream consists of. There’s just one problem: it’s a mirage.

That’s right, it doesn’t exist anymore. Long gone are the halcyon days of finding value left and right. Gone are the days where you could envision a new paradigm in investing and go out and make it happen. Instead, as information flow has exponentially increased, so has market efficiency. This fact is the downfall of the individual trader.

But first, let’s talk about what I mean by efficiency. A lot of people, way more than there should be, and even in the financial community, think that the market predicts that things will stay as they are and if you think the market is wrong, you can make money. For instance, the S&P is at about 2520 at the time of this writing. Many people think: “The market is pricing in this great economy, so if I think the market is wrong, and instead the economy is going to do poorly, then I can short the market and make money.”

But that’s fundamentally wrong because you don’t have to be right about the DIRECTION of the economy to make money, you have to be right about what the EXPECTATIONS of the market are as well AND you have to predict whether actual data will come in above (if you want to go long) or below (if you want to go short) what the market is expecting.

That’s the key factor many people, even finance professionals miss. But it’s drilled into your head at institutions such as the one I used to work for, Bridgewater Associates. You have to have a reason why expectations are wrong. And that is statistically extremely extremely rare and hard to come by.

Why is that? The reason is that expectations are set by experts who are better looking than you, smarter than you, and people like them more than you (harking back to the opposite of Stuart Smalley’s affirmation from SNL). So you might say, can we test that? And we can.

1. Let’s first test how accurate predictions are when done by experts. Turns out, they’re very accurate on a market wide basis (http://onlinelibrary.wiley.com/doi/10.1111/jofi.12060/full). In other words, forecasters are almost equally likely to be above as they are to be below expectations (This is NOT true of company earnings by the way. It’s been shown that company’s massage earnings so that they minimize the probability of a downside surprise).
2. Then let’s find out how often expectations are missed and the distribution of those misses. Turns out, it’s 50%, though apparently the predictability of the degree of market reaction should a miss occur is more predictable if you incorporate google search results into your model (https://papers.ssrn.com/sol3/papers.cfm?abstract_id=2913180).
3. Finally, are there areas where the market can be wrong? Turns out, yes, but those tend to be in highly nuanced areas such as extrapolating monetary policy expectations from aggregate earnings surprises (https://papers.ssrn.com/sol3/papers.cfm?abstract_id=2913180) and similarly arcane, and not all too useful niches in an otherwise highly efficient market.

So what does all this mean? It means that the market sets generally good expectations, that are unpredictably missed (a random walk model does better than most experts), and in areas where the market is wrong, it’s very hard to take advantage of those inefficiencies.

But, the market CAN be wrong. The problem is identifying where and when. Back in 2006, there was such an opportunity. Earnings of banks were projected based on nearly fraudulently priced, regulated, and securitized Collateral Debt Obligations (CDOs) tranched out from less than stellar performing Mortgage Backed Securities (MBSs), yet those CDOs were still given AA+ ratings. The whole market was fooled, and for a large amount of time. Those who predicted market error, made a fortune while the rest of the economy lost trillions.

Now think back to that period of time if you were around, and if you were in the market/in finance. What do you remember? Do you remember sayings like “but real estate always goes up?” or “home prices don’t go down” or “it’s a new securitization economy, that’s why my investment is secure”? Those, and many others, were typical sayings that helped the market reduce implied volatility to among the lowest levels of all time (coincidentally, only beaten out by how low implied volatility is at this very moment. It bottomed out at around 10.5% in November, 2006, and now it’s at 9.5%; and don’t worry, there’s no money to be made here either since the market has priced in the probability of increased volatility in the near future). But while those sayings were wrong, they were still so prevalent as to convince an entire economy that their money was far more secure than it was and only a very very very very few people saw through it.

Now, let’s say you think that you can profit from shorting the S&P 500 rather than the VIX since you can get exposure to the spot equity market. Unfortunately, like the implied volatility futures prices, the S&P 500 price has also taken all this information into account. So you’d have to have evidence that the S&P 500 companies and/or the economy will a) miss forecasts, and b) have consistent downside surprises (instead of upside surprises) if you want to short the market right now.

The point of all of this is to remind you how prohibitively difficult it is to beat the market and to remind you in no uncertain terms to NOT attempt it. I’ve already written a piece about market timing where I advise similarly (https://medium.com/@barrongati/dont-time-the-market-here-s-why-you-shouldn-t-6e777f9f68c0). The main reason you can look to is my rather rude imaginary conversation with people who think they can time the market. People say “I think the economy is going to do worse than expected” and to those people I ask “and who do you think you are?”

My point is to rudely awaken people to the hard truth that they’re not experts, and even if they were, experts tend not to beat the market either. You might have a friend who’s picked a whole bunch of stocks right a whole bunch of times. But you have to ask yourself: is he simply (inadvertently) taking advantage of high beta stocks (those that outperform the market simply by the virtue of their individual company risk profile), is he just lucky, or is he actually able to outperform a highly efficient market?

It can easily be the middle option of just luck. If we assume a 50% shot of outperforming the market on any given trade, and if we assume 250 million people are invested in the market, then there’s still just under 500,000 people who were right 10 times IN A ROW. Think about that. If I told you I was correct 10 times in a row, you’d rightfully say “that’s amazing” and you’d think about the odds of that (around one in a thousand) and you might go along with my next trade. But in an extremely large market, and given how difficult it is to beat the market, the most likely results is to believe that when one sees a series of events like that, it’s actually more likely to be the unlikely string of random events than that this person can actually be expected to beat the market.

So if NOBODY can beat the market, then why do hedge funds exist? The answer as you may have guessed by now is that some people ACTUALLY CAN beat the market. It’s just that finding those people, as Ray Dalio is known for saying, is just as hard as beating the market yourself. Either that, or you have to have $50,000,000 to plunk down as the minimum investment into firms like Bridgewater or AQR.

But more often than not, people selling you higher returns than the market are doing what’s known as “passing off beta as alpha.” In other words, they’re selling you individual company or sector returns, which are riskier than the market, and then charging you hedge fund prices.

Let’s say you had a financial advisor come to you in 2001 and say “hey, I’m a biotech expert, I know how to pick biotech companies so well that I can beat the market” and you go with him. Then, today, he shows you how well you’ve done and that he’s earned his high fees by providing this chart:

You might be ecstatic with that return. The problem is that you could have earned that return yourself simply by going long IBB (a biotech sector ETF) and holding it without doing ANY stock picking (in fact, that’s what the above graph shows). So you’d have paid higher fees than the 0.48% expense ratio IBB charges (probably something like 2% of assets and 20% of returns if the guy was doing hedge fund pricing) and you’d have gotten a terrible deal. Said another way, the correlation of IBB with the S&P 500 is 65%. And IBB’s (the ETF’s) beta is 1.32. So one way you could think about this is that the financial advisor would be providing you with exposure to the S&P (65% correlation to the overall market) and non-diversified exposure to the biotech sector (the >1 beta of IBB) while charging you an outlandish fee.

This logic holds for picking 1 company or 1 sector against the market. Overall, the goal for the regular investor should be to eliminate all diversifiable risk from their portfolio (I’ll cover diversifiable risk in the next article, but in short it is the risk of holding 1 company or 1 sector that can be eliminated by investing in the entire market instead). Full diversification allows for the highest return per unit risk.

That said, if you have some extreme area of expertise, then you might have a chance (such as extremely small cap companies that big funds simply cannot invest in because there’s not enough volume) to beat the market, but way more often than not, you don’t have a shot.

So as another SNL call back regularly said: Hear me now and believe me later!