It is never going to be worthwhile for a personal investor to attempt to beat the market.
That statement looks very iffy to me. I see it as a strong claim resting on a bunch of unstated assumptions and with no evidence to support it (don’t forget about the difference between “a personal investor” and “an average personal investor”).
Take a look at a graph of the the distribution of financial assets by net worth percentile. The typical share of stock is owned by a person or organization hundreds or thousands of times wealthier than you*. The bottom 90% of investors own together own less than a fifth of all equities, and less than 6% of other financial assets. Your competition in the stock market is not your neighbor—it’s a family office managing $200 million.
If a retail investor with $50K puts in the time and effort to beat the market by 5%, he can make an extra $2,500 per year. If a retiree with $10 million puts in the time and effort to beat the market by 5%, she can make an extra $500k per year. Beating the market’s a zero sum game. Who do you expect to win—the person who can hire two full time $200k-salaried money managers, or the person investing in their spare time?
*For the purposes of this comment, I’m assuming you live in the US and do not own more than a few hundred thousand dollars of stock.
No, not in general. Some markets are more or less zero-sum games (e.g. futures), some are not (e.g. equities).
Your competition in the stock market is not your neighbor—it’s a family office managing $200 million.
First, there are many more markets than just the (US) stock market.
Second, if you want to go in that direction, that family office is small fry. The behemoths of the market are institutional money managers—pension funds, for example. They, notably, have different success criteria and different incentives than individual investors.
Third, I don’t quite understand in which sense that family office is “competition”.
It is never going to be worthwhile for a personal investor to attempt to beat the market.
That statement looks very iffy to me.
Beating the market’s a zero sum game
No, not in general. Some markets are more or less zero-sum games (e.g. futures), some are not (e.g. equities).
By my reading, your reply about the structure of futures and equities markets equivocates on the word “market”. To me, the phrase “beating the market” means getting a higher expected return than average, which I think is zero-sum. Do you not think “beating the market” is zero-sum?
To me, the phrase “beating the market” means getting a higher expected return than average
Oh, and by the way, that’s not what this phrase means to most people. Its standard meaning is “achieve a return higher than that produced by buying and holding an portfolio of all assets in the given market”.
For example, let’s say that S&P500 returned 10% in year 20XX. This means that a portfolio of 500 stocks that constitute the S&P500 index has produced a 10% return for this year. Notably, this does NOT mean that the average return of all people who invested in some way in the US equity market is 10%.
To me, the phrase “beating the market” means getting a higher expected return than average
Its standard meaning is “achieve a return higher than that produced by buying and holding an portfolio of all assets in the given market”.
Excellent point—I tried using the fuzzy words “higher expected return than average” to drive home the zero-sumnes of the issue, but that phrasing does not reflect actually people mean by “beat the market”.
Let’s get concrete. What do you think are specific and realistic scenarios for an individual investor, with at most a few hundred thousand dollars in capital, to attempt to beat the market?
First counter-question: why should an individual investor care? Unless you perceive yourself to be in some sort of ranked competition (which is actually the case for professional money managers), why would you care about beating the market?
On a purely rational basis, you have a universe of investment opportunities. You evaluate, to the best of your ability, the future probability distributions of returns from all of them and some kind of a dependency structure (in the simple case, a covariance matrix). From these, you form a portfolio that best matches your risk-return preferences.
If you just want to “beat the market”, the simplest answer is leverage. Assuming you believe that the expectation for the equity market is positive, open a margin brokerage account and invest into a diversified equity portfolio on the margin. In the US the equity margin is limited by law to 2:1 (in most cases). Your expectation of return would be the double of the market return. The price that you pay is doubled volatility.
In the context of the US equity market another simple answer is high-beta stocks. Invest in a portfolio of such stocks and if the market return is positive your expected return would be higher. The price that you pay is again, increased volatility.
First counter-question: why should an individual investor care?
If I had $1 billion, even microscopic improvements in the yield of my investment would dominate any income I could hope to earn through wages. If I had $1, my investment yields wouldn’t matter—doubling my principle would be less remunerative than working a minimum wage job for 15 minutes. Somewhere in between owning $1 and $1 billion there is a net worth where it becomes worth it to switch from a generic roughly age appropriate portfolio to something more finely tuned. I had estimated that cutoff to be many times a person’s annual income. If the cutoff is lower than my estimate, then a lot more people should be learning modern portfolio theory.
You’re forgetting about the utility function. If you had a billion dollars, there’s no reason for you to care about the return of your investments at all, much less about microscopic improvements. On the other hand, if you’re retired and you’re living on the income from, say, a $100,000 portfolio, any additional percent that you can eke out is meaningful to you.
The real question is why do you consider the market portfolio (which, again, most of US residents understand as an S&P500-based index) to be the default?
For historical context, it certainly wasn’t the default for saving money for retirement, say, 50 years ago.
If you had a billion dollars, there’s no reason for you to care about the return of your investments at all, much less about microscopic improvements.
I don’t agree—if you have $1 billion, the marginal utility of an additional dollar is smaller than if you are normal individual investor, but the utility is still positive. More importantly, the second derivative of utility—the rate at which the marginal of utility diminishes—is much larger for an individual investor than for a billionaire. $10 million is about twice as good as $5 million for Bill Gates, but not for me. This implies, to me, that individual investors should be more risk-averse than larger investors, which supports the statement “It is never going to be worthwhile for a personal investor to attempt to beat the market”.
Could you give some specific and realistic scenarios where it would be rational for an individual investor, with at most a few hundred thousand dollars in capital, to attempt to beat the market? That’s what I’d like to discuss.
The real question is why do you consider the market portfolio (which, again, most of US residents understand as an S&P500-based index) to be the default? For historical context, it certainly wasn’t the default for saving money for retirement, say, 50 years ago.
I was under the impression that historically most were more concerned with safety than they are now, and less concerned with “beating the market”.
I’m laboring over the phrase “beat the market” so much because I believe that (1) many people think that they can do better (2) most can’t, even if they are smart (3) you shouldn’t try.
This implies, to me, that individual investors should be more risk-averse than larger investors, which supports the statement “It is never going to be worthwhile for a personal investor to attempt to beat the market”.
And, if an individual is able to (predictably) beat the market for whatever reason then it is overwhelmingly unlikely that their optimal strategy is to invest their own capital but nothing beyond that.
A relative of mine does predictably beat the market, and he would agree with you that he would make more money in the long run by investing the money of others. But he would disagree that this is an optimal strategy: his (economic) goal is to make enough money to live comfortably while doing a minimum of work. He reports a fair number of likeminded people among his acquaintances, some more successful at this than others.
Do you not think “beating the market” is zero-sum?
No, at least not without a whole bunch of additional qualifications.
Two simple examples. Let’s assume the “market” is S&P500.
Example 1: I leverage my investment 2:1 and buy and hold the market. A year passes, the market return was positive, my return was twice as big as the market return. I beat the market—who lost?
Example 2: I do not invest and stay in cash for the whole year. The market return was positive, I underperformed the market and so lost—who won?
I’ll write the cute answer (for other’s benefits, since I expect you’ve thought of it).
Mr. Example2 decided to duck out of the market this year and sells his 1 share of SPY for $100. He keeps the cash at his brokerage, and gets 1% interest. Fleeing to cash turned out to be a bad deal for his portfolio—Mr. Example2 “lost”.
What did Mr. Examples’s brokerage do with his $100 in cash? Why, they lent it to Mr. Example1! Mr. Example1 borrowed $100 to buy a share of SPY (from Mr. Example1). The broker charged Mr. Example1 1% interest, which they pass on to Mr. Example2. This leverage turned out to be a great idea for Mr. Example1′s portfolio—Mr. Example1 “won”.
So the cute answer to you questions is “the guy from the other example”.
(But I don’t think this the root of the issue, so let’s move to a different thread leaf)
That statement looks very iffy to me. I see it as a strong claim resting on a bunch of unstated assumptions and with no evidence to support it (don’t forget about the difference between “a personal investor” and “an average personal investor”).
I originally had ‘layman’ in there too but decided the statement was too wordy and the context sufficiently clear. In any case the strength of your disagreement and in particular “no evidence to support it” suggests to me that your disagreement may extend to a question of fact about how efficient the market is.
Yes, I suspect so :-) However the core of my objection is the transformation of something like “An average retail investor playing in the US equity market will not beat S&P500 returns” into “It is never going to be worthwhile for a personal investor to attempt to beat the market”. There are a great many markets in the world, not all of them are large and/or efficient, and, on top of that, the diversity of personal investors is much greater than the diversity of markets.
Not to mention that if you just leverage your investment a bit and the market in which you invest has a positive drift, then you will “beat the market” pretty trivially.
There are a great many markets in the world, not all of them are large and/or efficient, and, on top of that, the diversity of personal investors is much greater than the diversity of markets.
‘The’, not ‘a’ or ‘any’. Again, I chose to leave out any disambiguation and disclaimers beyond the pronoun choice, to avoid wordiness and because I thought no reasonable reader would misinterpret the statement. My instinct for pedantry that I so cruelly suppressed as ‘unduly socially awkward’ while writing my comment is now jeering “I told you so” at me. While such precautions come with a cost they at least serve to prevent this kind of exchange from time to time.
Just rename your instinct for pedantry “preference for clear and precise expression” and hoist your freak flag :-) Socially awkward on LW is a weird beast anyway :-D
To return to the original point, how about “Timing markets successfully requires either a rare (and VERY well-compensated) skill or access to some relevant non-public information. There is a strong prior that you don’t have any of those so convincing evidence is required to overcome it.”..?
Just rename your instinct for pedantry “preference for clear and precise expression”
Including excessive amounts of tangential qualifications and attempting to make statements immune to misinterpretation tends to make statements less clear.
To return to the original point, how about “Timing markets successfully requires either a rare (and VERY well-compensated) skill or access to some relevant non-public information. There is a strong prior that you don’t have any of those so convincing evidence is required to overcome it.”..?
That is another claim I might also make. It just isn’t particularly relevant to the immediate (and quoted) context in the reply in question. (You have been talking about an essentially different issue to the one I was engaging with, which is fine, but obviously I’m not going to accept paraphrasings that aren’t about my point at all.)
That statement looks very iffy to me. I see it as a strong claim resting on a bunch of unstated assumptions and with no evidence to support it (don’t forget about the difference between “a personal investor” and “an average personal investor”).
Take a look at a graph of the the distribution of financial assets by net worth percentile. The typical share of stock is owned by a person or organization hundreds or thousands of times wealthier than you*. The bottom 90% of investors own together own less than a fifth of all equities, and less than 6% of other financial assets. Your competition in the stock market is not your neighbor—it’s a family office managing $200 million.
If a retail investor with $50K puts in the time and effort to beat the market by 5%, he can make an extra $2,500 per year. If a retiree with $10 million puts in the time and effort to beat the market by 5%, she can make an extra $500k per year. Beating the market’s a zero sum game. Who do you expect to win—the person who can hire two full time $200k-salaried money managers, or the person investing in their spare time?
*For the purposes of this comment, I’m assuming you live in the US and do not own more than a few hundred thousand dollars of stock.
No, not in general. Some markets are more or less zero-sum games (e.g. futures), some are not (e.g. equities).
First, there are many more markets than just the (US) stock market.
Second, if you want to go in that direction, that family office is small fry. The behemoths of the market are institutional money managers—pension funds, for example. They, notably, have different success criteria and different incentives than individual investors.
Third, I don’t quite understand in which sense that family office is “competition”.
By my reading, your reply about the structure of futures and equities markets equivocates on the word “market”. To me, the phrase “beating the market” means getting a higher expected return than average, which I think is zero-sum. Do you not think “beating the market” is zero-sum?
Oh, and by the way, that’s not what this phrase means to most people. Its standard meaning is “achieve a return higher than that produced by buying and holding an portfolio of all assets in the given market”.
For example, let’s say that S&P500 returned 10% in year 20XX. This means that a portfolio of 500 stocks that constitute the S&P500 index has produced a 10% return for this year. Notably, this does NOT mean that the average return of all people who invested in some way in the US equity market is 10%.
Excellent point—I tried using the fuzzy words “higher expected return than average” to drive home the zero-sumnes of the issue, but that phrasing does not reflect actually people mean by “beat the market”.
Let’s get concrete. What do you think are specific and realistic scenarios for an individual investor, with at most a few hundred thousand dollars in capital, to attempt to beat the market?
First counter-question: why should an individual investor care? Unless you perceive yourself to be in some sort of ranked competition (which is actually the case for professional money managers), why would you care about beating the market?
On a purely rational basis, you have a universe of investment opportunities. You evaluate, to the best of your ability, the future probability distributions of returns from all of them and some kind of a dependency structure (in the simple case, a covariance matrix). From these, you form a portfolio that best matches your risk-return preferences.
If you just want to “beat the market”, the simplest answer is leverage. Assuming you believe that the expectation for the equity market is positive, open a margin brokerage account and invest into a diversified equity portfolio on the margin. In the US the equity margin is limited by law to 2:1 (in most cases). Your expectation of return would be the double of the market return. The price that you pay is doubled volatility.
In the context of the US equity market another simple answer is high-beta stocks. Invest in a portfolio of such stocks and if the market return is positive your expected return would be higher. The price that you pay is again, increased volatility.
If I had $1 billion, even microscopic improvements in the yield of my investment would dominate any income I could hope to earn through wages. If I had $1, my investment yields wouldn’t matter—doubling my principle would be less remunerative than working a minimum wage job for 15 minutes. Somewhere in between owning $1 and $1 billion there is a net worth where it becomes worth it to switch from a generic roughly age appropriate portfolio to something more finely tuned. I had estimated that cutoff to be many times a person’s annual income. If the cutoff is lower than my estimate, then a lot more people should be learning modern portfolio theory.
You’re forgetting about the utility function. If you had a billion dollars, there’s no reason for you to care about the return of your investments at all, much less about microscopic improvements. On the other hand, if you’re retired and you’re living on the income from, say, a $100,000 portfolio, any additional percent that you can eke out is meaningful to you.
The real question is why do you consider the market portfolio (which, again, most of US residents understand as an S&P500-based index) to be the default?
For historical context, it certainly wasn’t the default for saving money for retirement, say, 50 years ago.
I don’t agree—if you have $1 billion, the marginal utility of an additional dollar is smaller than if you are normal individual investor, but the utility is still positive. More importantly, the second derivative of utility—the rate at which the marginal of utility diminishes—is much larger for an individual investor than for a billionaire. $10 million is about twice as good as $5 million for Bill Gates, but not for me. This implies, to me, that individual investors should be more risk-averse than larger investors, which supports the statement “It is never going to be worthwhile for a personal investor to attempt to beat the market”.
Could you give some specific and realistic scenarios where it would be rational for an individual investor, with at most a few hundred thousand dollars in capital, to attempt to beat the market? That’s what I’d like to discuss.
I was under the impression that historically most were more concerned with safety than they are now, and less concerned with “beating the market”.
I’m laboring over the phrase “beat the market” so much because I believe that (1) many people think that they can do better (2) most can’t, even if they are smart (3) you shouldn’t try.
And, if an individual is able to (predictably) beat the market for whatever reason then it is overwhelmingly unlikely that their optimal strategy is to invest their own capital but nothing beyond that.
A relative of mine does predictably beat the market, and he would agree with you that he would make more money in the long run by investing the money of others. But he would disagree that this is an optimal strategy: his (economic) goal is to make enough money to live comfortably while doing a minimum of work. He reports a fair number of likeminded people among his acquaintances, some more successful at this than others.
Sorry, leaving on a trip in about an hour so I have to bow out of this discussion. But I’m sure it will come up again on LW… :-)
Aww. Well, it was fun while it lasted :-)
No, at least not without a whole bunch of additional qualifications.
Two simple examples. Let’s assume the “market” is S&P500.
Example 1: I leverage my investment 2:1 and buy and hold the market. A year passes, the market return was positive, my return was twice as big as the market return. I beat the market—who lost?
Example 2: I do not invest and stay in cash for the whole year. The market return was positive, I underperformed the market and so lost—who won?
I’ll write the cute answer (for other’s benefits, since I expect you’ve thought of it).
Mr. Example2 decided to duck out of the market this year and sells his 1 share of SPY for $100. He keeps the cash at his brokerage, and gets 1% interest. Fleeing to cash turned out to be a bad deal for his portfolio—Mr. Example2 “lost”.
What did Mr. Examples’s brokerage do with his $100 in cash? Why, they lent it to Mr. Example1! Mr. Example1 borrowed $100 to buy a share of SPY (from Mr. Example1). The broker charged Mr. Example1 1% interest, which they pass on to Mr. Example2. This leverage turned out to be a great idea for Mr. Example1′s portfolio—Mr. Example1 “won”.
So the cute answer to you questions is “the guy from the other example”.
(But I don’t think this the root of the issue, so let’s move to a different thread leaf)
1) The person who lent you the money, and who could instead have invested it the same way you did.
2) The person who bought the stock you could otherwise have bought.
Edit: Solipsist’s answer is better than mine.
I originally had ‘layman’ in there too but decided the statement was too wordy and the context sufficiently clear. In any case the strength of your disagreement and in particular “no evidence to support it” suggests to me that your disagreement may extend to a question of fact about how efficient the market is.
Yes, I suspect so :-) However the core of my objection is the transformation of something like “An average retail investor playing in the US equity market will not beat S&P500 returns” into “It is never going to be worthwhile for a personal investor to attempt to beat the market”. There are a great many markets in the world, not all of them are large and/or efficient, and, on top of that, the diversity of personal investors is much greater than the diversity of markets.
Not to mention that if you just leverage your investment a bit and the market in which you invest has a positive drift, then you will “beat the market” pretty trivially.
‘The’, not ‘a’ or ‘any’. Again, I chose to leave out any disambiguation and disclaimers beyond the pronoun choice, to avoid wordiness and because I thought no reasonable reader would misinterpret the statement. My instinct for pedantry that I so cruelly suppressed as ‘unduly socially awkward’ while writing my comment is now jeering “I told you so” at me. While such precautions come with a cost they at least serve to prevent this kind of exchange from time to time.
Just rename your instinct for pedantry “preference for clear and precise expression” and hoist your freak flag :-) Socially awkward on LW is a weird beast anyway :-D
To return to the original point, how about “Timing markets successfully requires either a rare (and VERY well-compensated) skill or access to some relevant non-public information. There is a strong prior that you don’t have any of those so convincing evidence is required to overcome it.”..?
Including excessive amounts of tangential qualifications and attempting to make statements immune to misinterpretation tends to make statements less clear.
That is another claim I might also make. It just isn’t particularly relevant to the immediate (and quoted) context in the reply in question. (You have been talking about an essentially different issue to the one I was engaging with, which is fine, but obviously I’m not going to accept paraphrasings that aren’t about my point at all.)
Well, I guess then I don’t understand what did you mean. Would you mind rephrasing your reply in a more clear and robust way?