In 2013, Eugene Fama of the University of Chicago was named Nobel Laureate in economics. His research on the efficiency of capital markets revealed that information on publicly traded companies is so quickly disseminated among investors that any effort at beating the stock market through the active selection of common stocks is likely to be met with dismal results.
His work was significant because it established a foundation for the choices you make within your portfolio, decisions that are likely to have a profound impact on your financial well-being throughout your retirement years. This is especially true in the current investing climate, with rates on bonds, bond funds, and other fixed-income investments hovering near all-time lows. Allocating a healthy portion of your portfolio to common stocks and maximizing the returns of this asset class are more important than ever before.
Let’s take a closer look.
For those investors intent on owning common stocks, there are three primary methods of investing in the stock market: You can purchase individual companies; you can invest in a mutual fund run by an active manager who picks stocks for you; or you can invest in all of companies that make up the stock market through an unmanaged mutual fund called an index fund.
You would think that professional stock pickers, along with their team of research analysts, could pick enough good companies and avoid enough bad companies to beat the stock market average, which is made up of good and not-so-good companies combined.
The concept of “beating the market” is drilled in to us by the Wall Street crowd. You see it on television ads, with global money managers traveling the world looking for undiscovered companies. You come across it when you log into your favorite financial website and a pop-up ad entices you to “Beat the Market, Get the App.” You hear about it at a backyard barbecue with your next-door neighbor touting his latest hot stock pick.
Are you intent on “beating the market” with your stock market investments? Let’s return to the work of Professor Fama for a moment. His study on the efficiency of markets should be a reminder to all of us that when you purchase stock in a publicly traded company, you aren’t really betting on the future success of the company. Instead, you are betting on your own power to predict the emotions of other investors and their expectations of a company’s success.
A company has nothing to do with the direct price of its stock. The price is set by the buy-and-sell decisions of the shareholders. As Fama pointed out in his early research, consistently beating the market through the selection of individual stocks is a mighty steep undertaking.
The numbers show this to be true. According to the S&P Indices Versus Active Funds (SPIVA) U.S. Scorecard, active managers underperformed their respective benchmarks across all market sectors for the three- and five-year period ending in 2013.
The debate over which is better — active or indexed — will never end. For some investors, settling for average just isn’t enough. On top of that, Wall Street has a huge financial incentive to continue promoting active management.
If you are intent on becoming a successful investor in the stock market, the question you need to ask yourself isn’t, “Can I beat the market?” because clearly it is possible, as Peter Lynch and Warren Buffett have proven. The relevant question you need to ask yourself is, “What is the price I pay if I try — and fail?”
For most investors, the price is extremely steep, and the more they try, the more they are likely to underperform. According to Boston-based Dalbar’s Quantiative Analysis of Investor Behavior, over the 20-year period ending in 2013, the average equity mutual fund investor traded mutual funds every 3.33 years, generating annualized returns of 4.97 percent, while the stock market returned 9.22 percent.
Capturing the market’s return through low-cost index funds is the ultimate “buy and hold” strategy — and a common-sense one to pursue for your retirement portfolio.