Beating the Market Is a New Idea

The Power of Passive InvestingToday we take it for granted that virtually all mutual funds and stock pickers are trying to earn higher returns than the overall market — or at least earn the same returns with lower risk. But Rick Ferri’s outstanding new book, The Power of Passive Investing (Wiley, 2010), reveals that beating the market hasn’t always been the goal of long-term investors.

When mutual funds first appeared in the 1920s, Ferri explains, there wasn’t even a generally accepted benchmark for the market as a whole: the Dow Jones Industrial Average had been around since 1896, but it contained just 12 companies (increased to 30 in 1928), was weighted by price, and has never been a good measure of the stock market as a whole.

The original goal of mutual funds, then, was to simply give small investors an opportunity to own a portfolio of stocks—something that was difficult and prohibitively expensive to do at that time. “Their mission,” Ferri writes, “was to select superior securities that paid reasonable dividends, to secure profits without undue speculation, and to conserve principal.”

Ben Graham: The first indexer?

Although Ferri doesn’t write about this specifically, you can make the same observation about stock pickers. Benjamin Graham’s The Intelligent Investor, first published in 1949, is still the bible of value investors. The book filled a genuine need at that time: if you wanted to be in the market, you had to know how to pick individual stocks. (Mutual funds were still in their infancy, and few investors had confidence in them after the Depression.) But Graham’s original readers were not necessarily trying to beat the market—they were simply trying to select prudent, profitable companies rather than engaging in speculation.

In fact, in a 1946 lecture, Graham remarked: “There is nothing to prevent the investor from actually buying the Dow Jones Industrial Average, though I never heard of anybody doing it. It seems to me it would make a great deal of sense if he did.” That might be the earliest endorsement of index investing on record.

Some 30 years later, shortly before his death in 1976, Graham did an interview with the Financial Analysts Journal in which he acknowledged that the average money manager could not beat the market: “That would mean the stock market experts as a whole could beat themselves — a logical contradiction.” For that reason, he said, investors should be content with the returns of the index.

How index funds changed the game

Beginning in the 1960s, Ferri writes, academics began doing research to see if they could identify skilled money managers. To their surprise, they found this was impossible: once they adjusted for risk, the academics could not separate skill from luck. Their data also determined that most active managers underperformed the market, and that investors would have been better off if they had just invested the S&P 500, which appeared in 1957. The money managers didn’t necessarily disagree with those findings, but they were quick to point out that “you can’t buy an index.”

In 1976, all that changed. That was the year that Vanguard created the first S&P 500 index fund for retail investors. Now, for all practical purposes, anyone could get the same return as the overall market (or at least the large-cap US market), and they could do so at very low cost. Predictably, the very idea was ridiculed at first — “Who would want average returns?” — but as it caught on, money managers were forced to justify their very existence.

Ferri points out that this represented “a titanic shift in industry ideology. For the first time, fund companies took the stand that it wasn’t enough to simply offer diversification through a pooled basket of securities that investors couldn’t achieve on their own at the same cost. The new mission was to beat the market.”

As a group, they have been failing in this mission for almost 90 years. In my next post, I’ll look at Ferri’s take on the probability that actively managed funds will outperform index funds over periods of five years and longer.

10 Responses to Beating the Market Is a New Idea

  1. Michel March 14, 2011 at 11:17 am #

    Good article! My humble opinion is that you should buy the index, supported by good dividend paying companies and a few higher beta stocks (tech, oil, gold, etc.). I never sell my div. stocks nor the indices, and I sell my other stocks normally at a profit. I dollar cost average my indices. This way, I stand a small chance of beting the market.

  2. The Dividend Pig March 15, 2011 at 9:30 am #

    Very interesting article. I never thought about it this way; but it makes total sense. I wonder how much return these early investors actually expected?

    Today’s investors expect an average of at least 9% (estimated) a year, over time, for stock returns. Would these first traders have been happy with 5%? Maybe 3%? With nothing to compare it to, would they have been ecstatic to get any return?

  3. Todd Hope March 18, 2011 at 4:16 pm #

    Over the very long term the S&P 500 will return 7 – 8%. If you are paying someone to help with investing your portfolio you should expect them to better this long term average by the amount they are charging you. Example: If you have a $10,000 portfolio and they are charging you $100 per year to manage it, they are charging you 1%, ($100/$10,000). So if you are not earning at least an average of 9% during the time span of the typical business cycle of 4 – 6 years I would say you are paying too much for that “help”. Too, if they are not keeping pace with the Index during a growth phase you might want to ask why and consider alternatives.

  4. Canadian Couch Potato March 18, 2011 at 4:55 pm #

    @Todd: Thanks for your comment. I disagree that investors should expect an advisor to deliver market beating returns. Of course, it’s true that many advisors see this as their role, and many investors expect it. But they are likely to be disappointed, as it is mathematically impossible for a majority of money managers to accomplish this goal. A good advisor will add value in other ways, not by helping you beat the market.

  5. Todd Hope March 18, 2011 at 5:46 pm #

    I agree that an advisor is there to add value and benefits. I guess it depends on the person as to what they are looking for from an advisor. For the record, I believe that index funds, like the ones that mimic the S&P 500, are a very good way for the average person to keep up with the market at a very low cost if they shop around enough or just read your article above.

  6. Open source portfolio March 21, 2011 at 4:01 pm #

    Of course this only holds true as long as only a small minority actually invests in indices. Once the vast majority turns to passive investing, outperforming should be much easier.

  7. dave777 February 6, 2012 at 4:04 am #

    I am going to come out with it. I don’t like advisers one bit. People should only use them while their portfolios are small and too busy with other life issues to be bothered managing money. Even then, there are dozen or so publicly traded actively managed funds out there that routinely outperform bank mutual options in any 2-3 year time frame. So I agree, especially in the 3-30 year investment time frame (long term). Wait until a market dip or a lull with a positive outlook then move in.

    But the big winners are those that invested in themselves by learning how markets work, read the materials before the markets open, have limit orders set for buy/sell then go off to work. Ask for prospectus material and read. Sounds like garbage until you get a hang of it. I made a lot of money from a rule in old 30’s something article I read decades ago.

    “If interest rates for saving go below real inflation for 2-3 months or longer, a depression or major recession is coming. Good time to average up the cash levels.” You would then have in 2006/07 seen 2008 a coming. Many advisers missed it, even big name in big companies.

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