Is beating the market harder than it’s ever been? Larry Swedroe thinks so, and he lays out his case in his newest book, The Incredible Shrinking Alpha.
PWL Capital has just published a custom edition of the book, with a foreword I co-wrote with my colleague Ben Felix. In our introduction, Ben and I note that Swedroe likes to use sports analogies when he discusses investing. I recently chatted with Swedroe about the book, and he looked to baseball and tennis to explain why active investors face more difficult obstacles than ever.
Outliers in the outfield
Swedroe begins with an argument that others have invoked before: the disappearance of the .400 hitter in baseball. Since 1903, seven different players have batted .400 or better a total of 12 times. However, that feat has not been accomplished since 1941, when Ted Williams hit .406 for the Boston Red Sox. “Of course, the skill of the pitchers today is much higher, and the fielders are much better,” he notes, so that might explain why batting .400 is considered almost impossible today. However, over the last 50 years, batting averages for the league as a whole have been roughly the same as they were during the early days: about .250 to .260. “You would think that batting averages would have come down, but that hasn’t happened,” Swedroe says. “The batting averages are about the same overall, but no one is hitting .400 anymore.” Why is that?
Blame it on the paradox of skill, an idea explored by Michael Maboussin in his book, The Success Equation: Untangling Skill and Luck in Business, Sports and Investing. The skill of both hitters and pitchers has improved dramatically over time, making the overall level of competition much tougher. As a result it is harder and harder for anyone to stand far above the crowd. Obviously some hitters are consistently better than others, but the range of batting averages at the major league level is narrower than it once was. You no longer see individuals batting 150 points above the league average, or players like Babe Ruth, who often hit more home runs than entire teams. The paradox of skill means that as everyone improves, the performance of each individual gets closer to the average.
In our interview, Swedroe offered a second analogy to drive home this point. “If you’re a tennis fan, you know that Novak Djokovic is the best player in the world today. Think about him going into the first round of a Grand Slam tournament: he’s going to play against some opponents who are not even among the top 100 players in the world. I don’t imagine he has lost a match like that in the last eight or 10 years, and he’s typically going to win them in very quick order. So when you have a wide disparity of skills, you have a wide dispersion of outcomes.” In other words, you have a lot of lopsided scores.
“But as Djokovic advances through the tournament and the competition gets tougher, the matches get closer,” Swedroe continues. “And by the time he gets to the final he’s probably playing Andy Murray or Roger Federer, and they are often having four or five-hour marathons, five sets, most of them in tiebreakers. So it is hard to generate big disparity in outcomes when the skill sets are very close.”
This raises another important implication of the paradox of skill. As the overall level of competition increases, luck plays an increasingly important role. When Djokovic plays the 200th best player in the world, luck isn’t a factor: he will win almost every time. But when he plays the second- or third-ranked opponent, the match will often come down to a shot that lands just inside the boundary line.
What does all of this have to do with investing? The analogies help explain why it’s becoming more difficult for fund managers to beat the market. “When Warren Buffett was competing against individuals like he was 60 years ago, you could get huge alpha,” Swedroe told me. “But when Warren Buffett is competing against nuclear physicists like he is today, it’s much harder. There’s no doubt that the competition is much tougher now, even compared with the 1990s. Today pretty much everyone is an MBA or PhD in finance. They’re all armed with the latest academic research, high-powered computers, and they are working at firms that hire world-class scientists and mathematicians. Where is your advantage? It’s really incredible to think that people like you or me are going to beat these people at the game. We would never think we can beat Djokovic. But somehow investors think they’re going to compete, and the odds of that are incredibly small.”