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Crazy Like a Fox

Jonathan Clements  |  October 26, 2019

THERE’S A MADNESS to crowds—but also great wisdom.

Each of us knows very little about the world. But between us, we know an extraordinary amount. Every time we buy or sell a stock, we each draw on the knowledge and insights we have, and we effectively vote on whether we think the stock’s price should be higher or lower. Because today’s market prices reflect our collective wisdom, it’s hard to find shares that are badly mispriced. Result: Over the long haul, we’re highly unlikely to overcome the drag from investment costs and outperform the market indexes.

Moreover, market prices don’t just tell us about underlying value. They can also be a good guide to the future. I have no idea what inflation will be over the next decade and I’ve seen scant evidence that the economy is slowing. But investors have offered their collective opinion: The difference in yield between conventional Treasury notes and inflation-indexed Treasurys suggests annual inflation will run at 1.6% over the next 10 years, while the recent inverted yield curve tells us that a recession is a distinct possibility.

But while markets can seem all-knowing, they can also seem utterly mad. Who hasn’t watched the movement of major indexes and individual investments, and thought, “That’s totally nuts”? Dot-com stocks in the late 1990s. Housing prices in 2005 and 2006. Global stock markets in early 2009. Bitcoin. Negative interest rates. Need I say more? When investors are collectively exuberant or scared, crazy things can happen.

So are crowds wise or foolish—or could they possibly be both? You see this quandary reflected in the ongoing debate over investors’ behavioral mistakes. Do these mistakes affect the market’s so-called efficiency—the degree to which market prices reflect underlying fundamentals?

Some experts argue that securities are always priced correctly. These experts don’t preclude the possibility that some investors act foolishly. But their foolishness isn’t sufficient to distort market prices, because their ignorant trades are cancelled out by the actions of better-informed investors.

Other observers allow that foolish investors can cause security prices to stray from what’s justified by underlying fundamentals. But these distortions are sufficiently random—and sufficiently costly to exploit—that the market remains extremely difficult to beat. I’m firmly in this camp.

But whether markets are always efficiently priced or not, the result is the same: We’re highly unlikely to outperform the market averages, which is why broad market index funds make so much sense. That contention is backed up by both logic and real-life evidence.

The logic: Before investment costs, investors collectively must match the performance of the market averages, because together we are the market. Meanwhile, after costs, we inevitably lag behind. To be sure, in any given year, some investors will get lucky and beat the averages. But as a group, we’re destined to trail the market by a sum equal to the investment costs we collectively incur. This isn’t just the opinion of some ink-stained wretch. Rather, it’s irrefutable logic.

What about the evidence? Consider three studies from S&P Global. First, there’s the so-called SPIVA study, which compares actively managed stock mutual funds to S&P indexes. Depending on the category, S&P found that between 79% and 98% of U.S. stock mutual funds failed to outperform their benchmark index over the 15 years through year-end 2018.

S&P Global conducts a similar study of institutional money managers—and the results from this second study are almost as dismal. After fees, 76% of institutional money managers focused on the U.S. stock market underperformed the broad market over the past 10 years.

While most money managers lag behind the market averages, a minority do indeed shine. Problem is, it’s awfully hard to identify these winning managers ahead of time. That brings us to the third study from S&P Global: Its “persistence scorecard’ looks at whether winning managers keep winning. The answer, alas, is no—which means buying actively managed funds with strong past performance is unlikely to garner us market-beating results.

The bottom line: Crowds can behave foolishly. But does that make the markets easy to beat? Only a fool would believe it.

Follow Jonathan on Twitter @ClementsMoney and on Facebook. His most recent articles include Guessing GameImproving the Odds and 50 Shades of Risk. Jonathan’s latest books: From Here to Financial Happiness and How to Think About Money.

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