There are some things in life which are much more difficult to do than you think. Beating the stock market is definitely one of them.
“How hard can it be?” people typically ask themselves. “I’m a bright and intelligent person. There’s plenty of advice in the media and on the internet about how to beat the market. And even if I can’t do it, surely I can find someone to do it for me. What’s the big problem?”
The investment blogger Peter Lazaroff encapsulated the problem very neatly in a recent blog post entitled How Markets Work:
“In 2017, the global stock market had 76.5 million trades per day worth $441 billion. The market prices you see at any given moment reflect the buying and selling by millions of market participants incorporating all known information about a company. These market participants are collectively highly educated and highly motivated. As a result, information is quickly incorporated into prices.”
In a nutshell, the market is like a giant super-computer which, at any given moment, gives the very latest, best-guess estimate of millions off traders around the world as to how much a particular security is worth. Be honest, do you really know something that all those people don’t? For that matter, does your broker or adviser or your favourite newspaper?
The other way, aside from stockpicking, in which people try to beat the market is through market timing — getting in and out at the right moment. Again, it seems deceptively straightforward. But because market returns tend to be concentrated in very short periods of time, the market timer has to be very accurate, and consistently so, to profit from their expertise.
This myth that beating the market is relatively straightforward is tackled in the second part of our video series on investor behaviour, Your Own Worst Enemy. In Part 1 we explored optimism bias and overconfidence and explained how, despite being helpful characteristics most of the time, they can sometimes catch us out. Investing is a good example.
In Part 2, we specifically look at the damage that optimism and overconfidence does to our investment returns with the help of Oxford economics professor Bent Flyvbjerg, behavioural finance expert Greg Davies, and investment author Mark Hebner.
Look out for Part 3 in this six-part series at the beginning of September. We’re going to be releasing a longer documentary on the subject early in 2019.
In Part 1 we explored optimism bias and how it works against us as investors. In Part 2, we’re going to look at how, specifically, it reduces our returns. But first, here’s a quick reminder of what we’re talking about.
Professor Bent Flyvbjerg from the University of Oxford says: “Optimism bias is a propensity that humans have to look at the future through rose-tinted glasses, so to look at the future in a more positive light than it’s actually warranted by what actually happens when the future gets here.
“I think the constant is that this is probably something evolutionary, that we need optimism to do what we do in life and to get up in the morning, to get married, to have children, to go to work. But, optimism may also trip us up, so we might actually miscalculate risks regarding things that are very important.”
Trying to beat the stock market is, itself, an example of optimism bias.. because it’s extremely hard to do.
You either need to do one or both of the following:
- pick stocks that will outperform in the future, and
- get in and out of the market at the right time.
The evidence shows that very few investors do either of those things consistently‚ and that includes the professionals. Part of the challenge investors face is separating the facts about equity investing from the myths perpetuated by the media.
Mark Hebner from Index Funds Advisors says: “I think one of the more common myths is that good companies are actually good investments. I think if investors were to think about what goes on in a trade, they might realise that that may not be the case.
“So, for example, let’s say there’s this wonderful company that the whole world admires, let’s call it Apple today, and I want to buy those shares from someone who’s already holding those Apple shares. Well, that individual is going to say, well, wait a minute, I don’t want to give up these great expected returns in the future unless you pay me for some of those today.
“And that’s why, in effect, there are basically no free lunches lying around. It’s because the seller demands a fair price given the greatest or goodness of the company.”
Another problem is what’s called skewness. In other words, it tends to be a small number of stocks that account for the bulk of market returns. Instinctively, you might think that the odds of picking a winner are 50:50 — like a coin flip. In fact they’re smaller than that. And remember, trading costs money. Every time you buy a stock you need it to outperform just to cover those costs.
OK, that’s stockpicking. What about market timing?
Mark Hebner from Index Funds Advisors says: “In short, the reason that market timers do so badly, is that nobody can see the future. I mean this should be obvious for investors, that the future is an unknown. We don’t know what’s going to happen a month from now, a day from now even, and this random unpredictable news is what drives prices.
“In essence, because market returns are so concentrated in very short periods of time, the market timer has to be very accurate, in fact we like to say they need to get lucky twice within each market cycle.”
In a paper on the likely gains from market timing, the Nobel Prize-winning economist William Sharpe calculated that market timers need to be accurate at least 74% of the time to make it worth their while.
In fact, studies show that the vast majority of market forecasters, with all the insight and resources they have at their disposal, come nowhere near that. That’s why market timing usually leaves you with lower investment returns, not higher. And yet we’re constantly tempted to give it a go.
Greg Davies from Oxford Risk says: “Well, arguably humans do this in all sorts of ways. We ascribe information to things that we want to believe for a start, so things that resinate with us we start to believe more and more in.
“People will pick up and listen to all manner of things, including horoscopes at the extreme. No ever acts, by the way, on numbers, no one buys return tradeoffs. What we buy are stories, and stories come with a degree of comfort attached to them.
“If I have a story that is intelligible to me, if I understand it, if it just seems intuitively right, then it creeps past my guard, and the minute it is past my guard, it becomes something that I’m comfortable believing and something that I want to believe and so I become over-confident in it.”
One way to reduce the negative impact of optimism bias — both our own and other people’s — is not to pay too much attention to day-to-day market financial news, and ignore market forecasts altogether.
We should also try to de-bias — by focussing on the empirical data on how hard it is to beat the market.
But there’s something even more important than that.
Bent Flyvbjerg says: “The real secret to getting bias out is not to make subjective decisions. You basically want to make decisions that are more or less automatic.
“So instead of trying to time the market you would say like, if you are investing, that I’m going to invest every three months on a specific date; I’m going to invest whatever I have at that moment. You’ll do better than if you try to save up your funds and figure out where the market is going and try to time the market.
“Optimism bias has to have an opportunity to kick in, right, and it’s only when we make subjective decisions that it kicks in. So the more you can eliminate those and go on autopilot, so to speak, the better off you will be in making investment decisions.”
Professor Flyvbjerg is also, incidentally, a strong advocate of index funds. Instead of trusting your own skills and instincts, or those of an investment professional, he says, it’s far better to invest in the whole market.
In short, don’t try to be too clever. Beating the market is much more difficult than it looks.