The Long Odds of Beating the Market

Odss of Beating the Market

Mutual Fund Performance, 1970 to June 20141

# of Funds % of Funds
Mutual fund universe in 1970 358 100.0%
Number of funds that survived the entire period 107 29.9%
# of funds that outperformed benchmark 45 12.6%
# of funds that outperformed benchmark by 2%+ 3 0.84%

The reality that beating the market is really hard is one that I think is starting to set in for a lot of investors. Simply put, the odds of beating the market are so low that it was almost a foregone conclusion that investors would start shifting away from actively managed strategies.

One sign of this is the data that tracks mutual fund inflows and outflows. While traditional active management shops like American Funds are shedding assets like they’re going out of style, index and passively managed fund families are growing at record pace.

I also see this phenomenon on a more anecdotal and personal level in conversations that I have with investors of all ages. It’s much less common these days for someone that I talk to not to have at least heard of index funds, for example, and at a minimum be curious about them.

The Insatiable Desire to Beat the Market

However, even in light of all of the evidence that attempting to beat the market is not a very sound strategy, I think most investors still believe it’s possible if you know what you’re doing.

More importantly, in their minds, they see beating the market as the ticket to success. In other words, their view might be best summed up as, “yeah, the odds of beating the market are low, but the rewards of doing so are too spectacular not to try.”

They might go on to reference Warren Buffett and Berkshire Hathaway before ultimately convincing themselves that beating the market can be done simply because their are living examples of such success.

Given this mindset as a starting point, I thought it would be interesting to consider the highly unlikely sequence of events that are required in order to actually beat the market. Using history as a guide and the track records of highly qualified and educated mutual fund managers, this is what would need to happen in order to achieve market-beating success:

    1. Select an actively-managed fund that performs well enough to avoid being liquidated or merged with another fund during your investment horizon.
    1. Remain invested in the fund through the inevitable storms when the manager underperforms for long periods of time (almost certainly causing you to second-guess your strategy).
  1. Benefit from gross alpha (excess returns before fund expenses) that is high enough to fully offset the fees of the fund and still pass along outperformance to you, the investor.

Let’s take a walk through each of these in a bit more detail to see just how unlikely it is for an investor to enter the active management gauntlet and come out successful on the other side.

How Long do Mutual Funds Live?

The short answer: Not very long.

If you started investing in 1970, you had 358 U.S. stock mutual funds to choose from2. Certainly a large pool, but nothing compared to the thousands of mutual funds and ETFs in the marketplace today.

Of those 358, only a shade over 100 existed as of June 2014. The rest were either closed/liquidated or merged with another fund. Simply put, that means you had a 3 in 10 chance of choosing a fund that merely managed to stay alive for 44 years. Pretty poor odds for what in reality isn’t that high of a bar for success.

It might seem surprising that so few funds were able to survive, but it really isn’t. The vast majority of actively managed mutual funds die premature deaths.

While we can’t say that the cause of death for every fund is bad performance, in most cases that is certainly the reason. Mutual fund companies don’t close winning funds very often because touting the performance of those funds is what keeps the active management asset gathering game alive.

Even the Winners Look Like Losers for Much of Their Life

Assuming we get past the first challenge by successfully choosing one of the roughly 100 funds that managed to avoid the axe, the second challenge might be even harder: Staying invested when things look really bleak.

A big misconception about winning managers is that they always outperform. In other words, investors mistakenly assume that the smartest managers not only beat the market, but they are consistent in doing so.

The folks at Research Affiliates looked into this and found that not only is outperformance rare, it is far from a steady ride along the way if you are lucky enough to experience it.

They measured this by tabulating the number of quarters during a fund’s lifetime in which it had underperformed its benchmark over the prior three-year period. Each quarter for which this was true, the fund was determined to be on the “watch list.” Presumably, an investor would be highly concerned by seeing three consecutive years of poor performance.

If you look at the same group of 358 funds that we started with, you would assume that the ourperforming funds would rarely if ever experience three straight years (12 consecutive quarters) if underperformance. That assumption would be very wrong.

In fact, the winning funds spent between 36% to 48% of their lives on the watch list!4 Think about that for a second. Even the very best funds looked absolutely pitiful for roughly 4 out of every 10 quarters. That’s 15 to 20 years out of the 44 year period where bailing out probably seemed like the right answer.

You’d need an unbelievable amount of faith in the manager and the strategy to stay invested with performance like that!

Overcoming Incredibly Long Odds for Insultingly Meager Rewards

So let’s assume that we were able to clear both the first and second hurdles. The next question is: What did we get for overcoming the long odds of beating the market?

Well, of the roughly 100 funds that stayed alive throughout the period, less than half (45) also managed to outperform their benchmark. That slices are odds of success down to a pretty grim 12.6%. Not good.

Unfortunately, that’s not the end of the bad news. Logically speaking, if we are going to bear the burden of a high risk that we will underperform, the rewards better be sweet enough to make it worth our while, right?

Unfortunately, that’s not the case when you endeavor to beat the market. Of that small group of 45 funds, just 3 managed to deliver returns of 2% or more in excess of their benchmark. Three funds!

To bring it full circle that means that of the 358 funds we started with, less than 1% (0.84% to be exact) delivered the kind of market-beating results that actually move the needle. The other 355 funds either performed so poorly that they were quietly taken to the woodshed or they roughly approximated their benchmark with almost certainly more risk.

If those odds don’t convince you to embrace passive investing, I’m not sure what will!

1. Hiring Good Managers is Hard? Ha! Try Keeping Them!, Fundamentals by Research Affiliates, November 2014
2. Ibid.
3. Ibid.
4. Flying High: RAFI at 10 Years, Fundamentals by Research Affiliates, March 2015

The Backpacker’s Guide to Investing – Part 2

Wealth Engineers Guide to Investing

In Part 1 of The Backpacker’s Guide to Investing, we talked about the importance of having a well-thought-out investment plan (as well as a backup plan, since the unexpected should always be expected).

I also shared why you should always take advantage of limited resources when they are available, because once they’re gone, they’re gone. This includes investing as soon as possible to lengthen your time horizon and the power of compound interest, as well as getting 100% of your employer’s match.

If you haven’t already read Part 1, I’d encourage you to start there first.

Today, we are going to talk about how weight affects what you pack on the trail and why I’m happy to wear some functional, but pretty ugly clothes in the backcountry. Here’s Part 2 of The Backpacker’s Guide to Investing:

4. Weight is Your Enemy

As a backpacker, you generally want to keep your pack as light as you possibly can. This not only spares your back from unnecessary strain, but it will also allow you to trek longer and further since you won’t be burning as much energy.

Likewise, as an investor, you need to keep as much weight out of your portfolio as you can. This weight primarily comes in the form of unnecessary commissions, investment expenses, and taxes.

It’s very common for a typical portfolio to be dragged down by 3% to 5% in fees, expenses, and taxes every year. If your portfolio is earning 6% to 8% per year, that’s a huge burden and will eat up 50% or more of your return.

That’s why you need to be very diligent about keeping your expenses to a reasonable level and employing a tax efficient investment strategy.

Simply put, don’t squander your hard-earned money by paying unnecessary commissions or fees. There’s absolutely no reason to pay a load to buy a mutual fund these days. Likewise, you shouldn’t be paying more than 0.20% to 0.40% in annual mutual fund or ETF expenses.

Finally, it’s critical to understand the tax implications of your investment decisions. Ignoring taxes can erode the return potential of your investments.

5. A Few Things are Worth the Extra Weight (or Cost)

Part of the enjoyment of venturing into the mountains is the reward of getting to camp near a lake, river, or other natural beauty.

Ideally, that means setting up your tent in the early- to mid-afternoon and still having several hours of sunlight to relax in.

To really get the most out of the trip, I always pack a few things that are absolutely worth the extra weight:

  1. Sandals – There is no better feeling than tossing your hiking boots aside and throwing on a pair of sandals after a long hike.
  2. A book – Whether it’s a paperback or a Kindle, being able to spend a few hours reading in the peacefulness of the wilderness is unbeatable.
  3. Coffee – It doesn’t weigh that much, but even if it did, no one is taking my morning cup of joe away from me.

I’ve also invested in several items that either help reduce weight or make for a much more enjoyable adventure. Are they more expensive than the alternatives? You bet. Are they worth every penny? You better believe it. Here are a couple:

  1. GSI Pinnacle DualistAs a backpacker, this is the greatest thing since sliced bread. It packs two bowls, two insulated mugs with lids, and two collapsible sporks all into a pot with a strainer lid. The pot then fits inside a molded stuff sack that doubles as a wash basin. On top of that, my ultralight stove and fuel fit inside. And the entire package weighs just 21.6 oz and is the size of a 6″ by 6″ box. It’s incredible.
  2. REI Lite-Core 1.5 Self-Inflating Sleeping PadSleeping on the ground isn’t fun. Neither is carrying one of the huge roll-up mats you can buy for $20. Instead, every backpacker should get a lightweight, compressible air pad. The one I bought from REI quite a few years ago weighs just 27 oz. and stuffs into a sack that measures only 5.5″ by 10.75″. It’s way more comfortable than the foam pads and takes up a lot less space.

When it comes to investing, the same principles apply. The costs of investing have come down dramatically. Almost to zero in some cases.

You can purchase index funds for free and the cost of ownership for a basic portfolio will run you 0.10% or so per year (and probably less after you factor in securities lending offsets).

Likewise, you can minimize taxes through smart planning. Obviously, this means maximizing tax-deferred and tax-free retirement accounts. It also means intelligent portfolio design and management in your taxable accounts.

However, are there instances when it’s worthwhile to carry a little extra weight or pay more for a better solution? I believe so. Here are a few examples:

  1. Diversifying internationally – Investing in international developed market stocks costs more than it does to buy U.S. companies. The same is true of emerging market stocks. However, both provide a clear opportunity to diversify the equity side of your portfolio and investors would be foolish to pass up the opportunity.
  2. Diversifying across risk factors – Likewise, employing a factor-based investment approach, whereby you seek to invest in specific types of stocks with unique risk/return characteristics is also more expensive. That said, the diversification benefits and higher expected returns from smaller stocks, value/low-price stocks, profitable companies, etc. clearly outweigh the higher expenses of owning such funds.
  3. Professional advice – I’ll start this by saying I could easily be accused of having a bias here, but I’ll make what I believe is a genuine case anyway. I believe that unbiased, high-quality advice is often worth more than you pay for it. This can be true with anything from hiring a lawyer to getting a home inspection. Sometimes that advice protects you from making poor decisions or finding yourself in hot water. Other times professional advice can add a significant amount to your bottom line. In still other cases, the time and effort you save by hiring a professional is worth it to free your life up for other things. When it comes to working with my clients, it’s almost always a mix of all three.

John Bogle is famous for saying, “In investing, you get what you don’t pay for.” In general, he’s absolutely right. However, I think smart investors would agree that there are indeed a few things that break that rule of thumb.

6. There are No Points for Style

There are several things that I wear on a backpacking trip that I wouldn’t exactly call fashionable. In fact, the only times that I wear or use these things are on hiking trips.

Such items include a sun hat, a mosquito net, and pants that convert into shorts.

Why do I wear them? Because they work. Without these things, my trip would either be miserable or would require me to pack extra weight.

As investors, not a day goes by that we don’t hear about the latest hot investment or guaranteed way to make money. Whether on CNBC, in the Wall Street Journal, or at a networking event, who hasn’t had been intrigued by one or more of the following:

1) Hot stocks, IPOs, or fund managers
2) Non-public real estate investments or developments
3) Private equity
4) Hedge funds
5) Start-up businesses or angel investments
6) Currency trading
7) Wall Street products that provide “market upside and no downside”

I could go on and on. However, the independent research and evidence behind such investments, isn’t good.

The returns rarely hold up to the lofty promises of the people who pitch the investment, particularly after you adjust for fees, taxes, and risk.

And you’d better carefully understand the risks. Far too many times I’ve seen investors lose large sums of money or find themselves personally on the hook for debt because they didn’t take the time to understand the commitment they were making.

That’s why, the message about investing should be clear: There are no points for style!

Returns aren’t delivered because an investment sounds exciting or makes for entertaining conversation at a cocktail party.

The majority of strategies and investments that have a strong track record of delivering results for individual investors are somewhat lacking in panache: diversification, asset allocation, discipline, low fees, low taxes, index funds, etc.

If you want to buy the latest “hot” investment, just remember that it will likely do more for your talking points at a party than it will for your bottom line.

Part 2 Wrap Up

I’m sure there are more parallels between backpacking and investing that I’ve missed. However, the points at the end of the day are pretty simple:

  1. Have a well-thought out, written plan
  2. Prepare in advance for bumps in the road
  3. Don’t miss out on critical, but limited opportunities
  4. Avoid unnecessary weight that limits how far you can go and how fast you can get there
  5. Know when carrying some extra weight or paying for better stuff is worthwhile
  6. Seek function over form if you want to be successful

If you follow these tips, I’m very confident you’ll do well. If you’d like some help, let me know.

5 More Investing Facts Every Investor Should Know


In a previous post, we looked at five critical investing facts that every investor should know. These included the “math” behind beating the market, an honest assessment of the returns delivered by index funds, and several others.

I would encourage you to read that post first before proceeding with this one.

Today we are going to look at five more investing facts that every investor should know.

Keep these in mind during both good markets and bad. I promise you’ll find yourself in much better shape than the typical investor.

Investing Fact #6

Investors who ignore taxes do so at their own peril

One of the most significant, but often overlooked, challenges associated with strategies that attempt to “beat the market” is the impact of taxes.

This is one of the reasons why performance and returns are typically stated on a pre-tax basis. Only recently have we seen any attention being paid to the tax costs associated with mutual funds, hedge funds, and other investment vehicles.

In a taxable account, however, you simply can’t afford to ignore taxes. Several studies have demonstrated that a typical actively managed strategy will incur 2% to 3% in annual tax costs above that of a simple index fund.

Keep in mind, that 2% to 3% number comes directly out of your annual return. In other words, if you earn 7% before taxes, your return would dip to 4% to 5% after taxes.

Simply put, this means a manager would need to generate alpha on the same order just to break-even on an after-tax basis. The unfortunate reality is that very few fund managers have shown a consistent ability to deliver after-fee alpha of any kind, let alone 2% to 3% per year.

For that reason, we need to be acutely aware of turnover, capital gains, and asset location when it comes to portfolio design. If not, we run the risk of lining Uncle Sam’s pockets at the expense of our own.

Investing Fact #7

Owning individual stocks is rarely necessary (or beneficial)

A lot of people assume that step one in developing an investment plan is knowing which stocks to buy and which to avoid.

Unfortunately, as many well-respected people have found, there is very little evidence that even the smartest fund managers can pick the right stocks to outperform their benchmark.

For individual investors, the situation typically worsens for two reasons:

  1. It is very difficult to properly diversify with individual stocks unless you have a very large portfolio
  2. The transaction costs of buying enough stocks to achieve proper diversification often eliminates any potential for market-beating returns

Although Jim Cramer and other talking heads would like you to believe you can build a diversified portfolio with as few as 10 to 15 stocks, that simply isn’t true.

Even in an asset class like large cap U.S. stocks (which is the easiest to diversify in), you need somewhere on the order of 60 to 100.

Once you move in to small cap stocks, for example, you need to own several hundred (at a minimum) to successfully diversify away unrewarded risks.

The primary instance when owning individual stocks would be helpful is in a large taxable account with low, negotiated transaction costs. Such a portfolio would allow the manager to custom-tailor the portfolio to the tax profile of the investor. This can be a sound, low-risk way to increase after-tax returns.

Ultimately, however, for most investors individual stocks does far more harm than good.

Investing Fact #8

There is no “right time” to be buying or selling

It’s very easy to play Monday morning quarterback in the world of investing.

“That was clearly a time of irrational investor behavior.”

“The writing was on the wall that stocks were overbought. How did you not see it?”

However, as the saying goes, “hindsight is always 20/20.” In reality, studies of professional forecasters have shown that following their recommendations leads to no better a chance at being right than the flip of a coin.

Even the most powerful statistical predictors of market valuation only explain about 40% future real stock returns.

In fact, rainfall (yes, the rain that comes out of the sky) does a better job predicting returns than some of the common metrics (such as consensus GDP growth or the trend of earnings) you hear spouted by the “gurus.”

In addition, in a world where literally millions of transactions are taking place every day (most of them between sophisticated institutional investors), investors need to ask themselves: What do I know that everyone else doesn’t?

Remember, all stocks are owned at all times by someone. Thus, if you sell, someone else must buy. If you buy, someone else must sell.

So at the end of the day, if your opinion about the market or a stock leads you to make a trade, someone must be willing to take the other side. Do you know something they don’t?

Investing Fact #9

Diversification is the only (yes, the only) free lunch

If the facts I’ve covered up until now haven’t made it clear, eliminating unnecessary risks and potential hindrances from your portfolio should be a top priority.

We’ve covered costs, taxes, active manager risk, and market timing risk, thus far. We’ve also briefly spent some time talking about diversification as it relates to owning individual stocks.

However, diversification is such a critical topic that it deserves a discussion of its own.

And, unfortunately, most investor portfolios are severely under-diversified.

They are typically concentrated in stocks of large. U.S. companies, meaning they lack appropriate diversification from both a geographic and asset class perspective. Specifically, almost every investor portfolio would benefit from a reallocation that also included:

With the low cost mutual funds and ETFs available to investors today, insufficient diversification isn’t a problem that we should burden ourselves with. It really, truly is the only free lunch and it makes no sense whatsoever to fail to take advantage of it. Thus, my advice is as follows:

When in doubt, diversify. When you’re confident, diversify. I don’t care what your state of mind, diversify!

Investing Fact #10

Where you invest is just as important as what you invest in

When most people think about investing, the first thought that usually enters their mind is “what should I invest in?”

What you choose to invest in, however, isn’t even the first question you should be asking yourself.

Rather, you need to decide where you will invest your money. And I don’t mean where in terms of geography (i.e. U.S. stocks vs. international stocks).

I mean where like what type of account your money will go into. Before you do anything else, you need to devise a plan around your asset location.

Whether through your 401k, 403b, or an IRA, you almost certainly have access to a tax-advantaged account that deserves your money before a taxable brokerage or mutual fund account.

The reason being is that the tax advantages of retirement accounts really add up over time (potentially to the tune of 20% to 30% higher returns). In addition, if your employer matches your contribution to your 401k or 403b, you should be looking to capture the full match every year. Trust me, you won’d find a better return on your money anywhere.

Thus, before you start worrying about what to buy in your portfolio, decide where you should buy it first.