Myth: Complex Investment Schemes Work Best

The Word on the Street There is a prevailing notion in our society that it is possible to get extraordinary returns out of the stock market by following a particular investment strategy, buying certain sectors of the market, finding stocks with certain characteristics, or in hiring a sharp-dressed, smooth talking account manager.

The Truth While I do not deny that it certainly should be possible to “beat the market”, the simple fact is that, based on historical stock market and mutual fund data, very few account managers or mutual funds have managed to beat the market for more than a few years at a time.

It’s in the Pudding

One of my current favorite finance books is called A Random Walk Down Wall Street, by Dr. Burton G. Malkiel. Dr. Malkiel updates this amazing book every few years with the latest information available in the financial world, and the book is currently in it’s 36th year of publication! The reason that I mention this book here is because one of Dr. Malkiel’s major points is that very few, if any, active investors and fund managers actually beat the market for more than a few consecutive years.

Mutual fund companies have strong motivations to make their funds look really good, so they have a tendency to use a little creativity when it comes to the statistics they report in regards to their funds. A prime tweaking technique involves elimination of underperforming funds from their portfolio of offerings. By closing a “loser” fund, the poor returns it was providing are removed from the pool of statistics used to measure the average return of the funds the company offers.

If you want a prime example of a particular strategy working for a short period of time, then failing, look no further than the dot com boom. For a number of years, the investing mantra was “invest in dot coms, and you can’t go wrong!” Well, history has proven that that strategy was not a long-term success, and most of the fortunes created by that strategy were also lost by that strategy.

Critics of Dr. Malkiel’s premise often will cite the success of a few private investors as proof that high returns can be earned. They cite the success of Peter Lynch (who had excellent returns on his Magellan Fund for a number of years), and Warren Buffett, whose very name is synonymous with investing prowess. But, the reality is, that though there may be a few who can in fact beat the market, they are vastly offset by the numbers of those who not only can’t, but haven’t matched the market. How many successful investors have you ever heard of? One? Two? A dozen? A hundred? A hundred sounds like a lot, but at this very moment there are more than 9000 mutual funds currently available, and many thousands more that have already been closed. The media focuses on the very exceptional few, and tends to ignore the immense mass of investors who have not managed to outperform the market.

Buffett and I

Many of you who frequent the blog know my preferred investment strategy. I am a believer in efficient markets, which basically means that I, like Dr. Malkiel, don’t think you can expect to beat the market. So, if you can’t beat ‘em, join ‘em, right? I think the best approach is to simply purchase an exchange traded fund (commonly referred to as an ETF), or a mutual fund that tracks one of the major indices of the economy. Examples of such indices include the S&P 500, NASDAQ, Dow Jones Industrial Average, Russell 2000, etc. These funds have very low expenses because they are not actively managed, and do not trade stocks around very often. As a result, you manage to efficiently invest your money in the entire market. One great benefit of index investing is that you automatically get access to a phenomenal degree of diversification, which lowers the total risk of your investment.

In a recent interview with PBS’s Nightly Business Report, investing legend Warren Buffett had the following to say in regards to the complexity of the investment world:

You should always stick to what you know. I say the “know-nothing investor” and there’s nothing wrong with being a “know-nothing investor.” I spend 60 hours a week, thinking about investments and most people have got jobs and other things to do. They can buy index funds. And they’re not going to do better then an index fund if they go around and trust some guy who’s promising them very high returns. If you buy a cross section of American business and you don’t buy it during a period when everybody is all enthused about stock, you’re going to do fine over 10 or 20 years. If you buy something with the idea that you’re going to do fine over 10 months, you may or may not. I do not know what stock is going be up 10 months from now, and I never will.

Warren Buffett

If you want to try to play roulette with your money, then go ahead and try to find the >1% of fund managers who will beat the market for more than a few years. For me, I am going to stick with the market, and almost guarantee that I will outperform 99% of all money managers.

Posted on 19 May 2009