If you read my last post, one of your first reactions might have been, “If these strategies are so effective, why isn’t everyone doing it?” Or, why aren’t you in charge of a big hedge fund, why isn’t every pension/trust fund using it, etc. (these are actual responses I’ve heard from people).
And while O’Shaughnessy covers this very question brilliantly in the first three chapters of What Works on Wall Street, I will make a feeble attempt in this post to begin to answer the skeptics. (He also has commentary on these topics, including “The Myth of the Most Efficient Market” and many others, on his asset management firm‘s website).
To begin, let’s review the obvious: everyone isn’t doing it, especially not managers of equity funds.
|% of actively managed funds underperforming the S&P 500 on a 10-year return
On average between 1991 and 2009, 70% of actively managed funds had 10-year returns worse than the S&P 500. Vanguard has more recent (and more complete) data in its case for index-fund investing, shown below.
|% of actively managed funds underperforming their benchmark on a 5-year return
(click to enlarge)
For the data and time period Vanguard looked at, actively managed funds underperformed their benchmarks two-thirds of the time on a 5-year return (a pretty strong case to not invest in actively managed funds).
So why, if strategies like trending value and the other 222 strategies that outperformed the S&P 500 between 1964 and 2009 are so lucrative, aren’t these equity fund managers able to beat the market?
Identifying the factors that outperform the market is easy. It’s a well documented fact that value investing over long periods of time will outperform the market (even Warren Buffet knows the value of value investing!). This is the basis for the trending value strategy I previously discussed. If the underlying indicators are obvious, who is left to blame? The investor’s brain is a good place to start.
Indexing the S&P works because it’s a strategy that never varies. Day in and day out, it the S&P 500 is an index of large cap stocks. It doesn’t decide one year, “Oh small stocks are doing well recently, maybe I’ll become a small cap index!” No, it stays the course.
As an individual investor (or as the manager of an equity fund, where it’s literally your job to not lose your clients’ money), would you have stayed the course through the 7 years between 1964 and 2009 that the trending value strategy underperformed the S&P 500?
|Difference in CAGR, Trending Value Strategy minus All Stocks
When the strategy lags 20%+ behind the rest of the market (like it did in 1999 and 2009, shown above), are you really going to stick with it? Not likely — fear/risk avoidance is wired into the deepest parts of your brain, an extremely useful feature for species survival, but not so useful for being disciplined in your investment strategy. (And if you stuck with it as a professional asset manager, you’d be fired).
A 2005 study found that brain-damaged people make better investment decisions than able-brained people, by being more willing to take risks and less likely to react emotionally to losses. The brain-damaged people ended up with 13% more money on average at the end of 20 mock investment rounds.
This is a brilliant market-timing game that shows you just how difficult it is to try to beat the market on a short-term basis. If you don’t do well on that game, don’t feel bad, not even Isaac Newton could to outsmart the market in the short-term. Or millions of other investors, as evidenced by recent history.
At the bottom of the Great Recession in Feb/March 2009, there was a net outflux of equity of over $50B (in just those 2 months; $9B net outflow over the year), as the influx into the bond market that year was $375B. Those who sold at the bottom not only realized their 50% losses, but missed out on the 159% rebound since then. They did it despite decades of past data and experience suggesting that the market would rebound.
So what’s the takeaway? Discipline is the key to the individual investor hoping to implement a strategy proven to outperform the market over the long term.
“Human beings, who are almost unique in having the ability to learn from the experience of others, are also remarkable for their apparent disclination to do so.”
– Douglas Adams