Many investors are tempted to try various strategies to beat the market. (That is, to outperform the major stock market indices.) Some people like to pick stocks. Others attempt to pick winning mutual funds. Others have determined that it can be done using regular index funds and timing their investments so as to avoid downward movements in the market.
As far as I can tell, this desire is simply the result of people’s tendency to estimate their own skills as above average. Apparently, nearly all of us engage in this logical fallacy in a number of ways. Investing seems to be one of them.
As a Whole, It’s Impossible for Us to Outperform
When considered as a single group, it’s impossible for investors to outperform the market. Simple math tells us that–as a group–we must earn exactly the market’s returns. (Actually, we earn the market’s returns, minus the sum of our total investment costs, but that’s a post for another day.)
It would seem logical to conclude, then, that for each person who outperforms the market, there must be somebody who is underperforming the market. The more precise conclusion, however, is that for each investment dollar that is outperforming, there must be another dollar that is underperforming.
Simplified Example: If the market had only ten investors, and one of them had as much money as the other nine combined, it’s possible that all nine of the poorer investors could be underperforming the market, while the one wealthy investor is outperforming the market.
Thus, in order for our investment dollars to outperform the market, somebody’s investment dollars must be underperforming by an equal amount. In order to accurately gauge our likelihood of success in such an endeavor, it would seem wise to consider who, precisely, our competition is.
It’s Not Just Your Day-Trader Neighbor
If all we had to do to outperform the market was be smarter/more clever than the average individual investor, it might not be so difficult. After all, there are plenty of people out there who don’t really know what they’re doing.
Unfortunately–at least for the probability of our being able to beat the market–the majority of the investment dollars we’d be competing with are not controlled by your Average Joe. In fact, only 34% of U.S. stocks are owned in individual accounts by individual investors. That means that two-thirds of our competition is made up of mutual fund managers, pension funds, insurance companies, trusts/foundations, and banks.
So if you decide to try and beat the market, what you’re really betting on is your ability to outperform teams of full-time professionals. Teams with well-funded, well-staffed research departments.
If you’re confident that you can beat them, then (you’re probably deluding yourself, but) go ahead and try. It just seems prudent to know who you’re up against.