How to outperform Investment Managers at their own jobs
I used to think that investing success depended on how much research I did on the companies I invested in. The more I knew about the company, the more prepared I’d be when making that investment. I can run financial models to determine if stocks were “undervalued” and “overvalued”. I can stare at stock charts all day to analyze trends and make projections. This was wrong on so many levels. Here’s why:
Over 80% of the stock market is owned by institutional investors. This means that all the smart money managers that invest on behalf of pension funds, mutual funds, and other large institutional funds are the primary reason stock prices move. Their research and analysis influences their buying/selling decisions. The prices are dictated largely by the buying and selling action/decisions of these institutional investment managers which hold large volumes of stock and trade with each other. The small potatoes like myself and other individual investors can do very little to change the stock price because we don’t own enough stock in the specific company to affect its price.
These investment managers are all competing against each other. They are all incredibly smart. They spend millions of dollars a year on their investment manager team to create financial models, analyze macro-economic trends, and research everything they need to know about the company.
Assume at the beginning of the year, there’s only 100 investment managers that collectively own the entire stock market. They are all competing against each other to become the top performing investment manager of the year.
At any point in time, some of these individuals can choose not to hold any or part of the stock(s) and sell them to the other investment managers. These investment managers would only be able to sell the stocks at prices that the buyers agree to pay for (based on what they think the company is worth).
At the end of the year, the collective performance of all the stocks/investment managers would be the average rate of return or market rate of return. By the law of averages, 50 or half of the investment managers would beat the market rate and 50 or the other half would underperform the market.
If we ran the same competition for a second year, only 25 of the investment managers (half of the 50 previous year’s above average performers) would be able to beat the market for two consecutive years.
If we ran the same competition for third year, only 12.5 (half of the 25 previous year’s above average performers) of the investment managers would be able to beat the market for three consecutive years.
If we ran the same competition for a fourth year, only 6.25 (half of the 12.5 previous year’s above average performers) of the investment managers would be able to beat the market for four consecutive years.
The point I’m trying to make is that it’s extremely difficult for investment managers to consistently outperform the market over time. It’s inevitable; even the greatest investment managers will underperform the average rate of return in the stock market at a point in time.
It’s very hard to predict which investment managers will be able to beat the market ahead of time. I hate to say it but it’s completely random and not based on skill. When you put the smartest people in the world which is what happens in the stock market, these institutional investors that hold almost all the stocks set the price that the company is worth. The current stock price is what the company is worth. It’s the price that the sellers of the stocks are willing to sell at. If the stock was “undervalued” why would they be willing to sell it for that price?
The Main Point
If you’ve managed to get through this post, imagine I was the 100th investment manager in the above example. Assume that I did no research, and owned all the stocks (in the same proportion as the overall market) during this period and let the smart money managers duel it out amongst themselves with the buying and selling stuff. This is what would have happened:
At the end of the year, I would earn the average rate of return of all the investment managers or the market rate. I would beat the performance of half the investment managers in the world by just holding all the stocks and doing nothing. I didn’t have to pay millions of dollars that these investment managers had to pay to hire an investment team and still be at below average performance which was 50 of them.
If we ran the same competition for a second, third, fourth, and future years, I’d still earn the average rate of return, and beat the performance of 50 investment managers that underperformed in each of these specific years.
When I was in university, if you had asked me if I thought I could ever outperform investment managers that invest in stocks for a living, I don’t think I would’ve imagined it’d be possible.
This imagination is now a reality and it’s possible for everyday investors like you and myself. It’s called “index investing” which I’ll talk about more in later posts.