Beating the market is hard to do. And it is not just hard – like running a marathon is hard. Trying to beat the market is laden with peril because you have to risk money. So when I say beating the market is hard, I mean it in the sense of “walking a tight rope without a safety net” rather than “running a marathon.”
A mathematical impossibility
The first step in understanding how investments work is to accept that we can’t all beat the market. It is mathematically impossible, and yet there is no shortage of advice from seemingly reputable sources claiming a clear path to beating the market — “Just follow a few simple steps!” Google “beat the market” and see what comes up.
Conventional wisdom posits that the market average return is a sort of baseline, kind of like a 2.0 “C” average GPA in high school. Merely applying a little wisdom and skill should beat this bogey; only the worst of investors can’t beat the simple market averages.
Two sides to everything
The reality is we can’t all beat the market average because, in aggregate, all investors make up the market average. For every dollar that one investor outperforms the market, another investor must underperform. There is always another investor on the other side of every transaction. If you made money because you sold Apple at $700 per share, that means another investor lost money because they bought it from you at that price.
What about the Sweet 16?
What about a savvy and/or well informed investor — shouldn’t they be able to wrestle gains from foolish investors? Numerous studies point to “No,” because there are a lot of other smart investors out there, all competing for gains. If you know a company is great, chances are lot of other people do too, driving up the price and lowering future returns. It is more akin to betting on the NCAA basketball tournament brackets where the payoff for choosing the good teams is small. As I understand it, the best strategy in NCAA basketball betting is to actually choose all of the bad teams.
There are a lot of subtleties to the concept of “beating the market.” For example, what “market” are you talking about? The US Stock Market? The bond market? Maybe a small company index like the Russell 2000? Understanding these subtleties is critical, but the overarching concept remains the same – beating the market is more difficult and risky than most people realize. The sooner they realize this the better.