Why You Won’t Outsmart the Market
What’s the magic formula to be a superior investor?
It’s no secret that we humans are competitive creatures. Anytime there’s a system, we want to beat it. We want to outsmart those around us. We want to identify the secret to winning.
In investing, this is an especially pervasive idea. I once had a woman tell me her main financial goal for the year was to beat the S&P 500 Index. I asked her why she selected that particular goal. She seemed confused that I would even ask.
As prevalent as this line of thinking is, it’s one that’s not easily done. Professional money managers, with all of the resources at their disposal, consistently underperform the indexes. Complex strategies, embraced by endowments and the ultra-wealthy, do even worse.
Why is it so hard to just out-invest everyone else? Why have we not yet harnessed our competitive instinct and figured out how to beat the market? Here’s why:
The market is constantly adapting to itself.
Adaptive market hypothesis says that the market is constantly adapting to itself. When one person discovers a magic formula to better returns, it’s only a matter of time until the rest of us discover it too. If somebody figures out a successful loophole, so many people flock to it that it often becomes unsuccessful.
If making a lot of money was easy, everyone would do it.
Another investor asked me to evaluate a prospective investment they were considering. They were enamored by the glossy marketing materials that pitched a sweet deal with great returns and reportedly little risk.
The first thing I wondered as I read the proposal was, “If this were true, why wouldn’t everyone just do this?” The answer, of course, what that there was a catch. If something seems too good to be true, be very skeptical.
Trying to beat the market means trying to beat ourselves.
In his book A Random Walk Down Wall Street: The Time-Tested Strategy for Successful Investing, author Burton G. Malkiel crafts an analogy. The market is kind of like a group of people participating in a fictional newspaper beauty contest, in which readers choose the six most attractive faces — and the people who pick the most popular faces get the prize.
A naive reader would simply select the faces they found most attractive. But someone more sophisticated would think beyond their own perception, choosing instead the faces that they believe the majority would select as attractive. Of course, this requires an accurate understanding of what other people perceive as beauty.
So it is in a style of investing that’s trying to beat everyone else: everyone in the market is constantly trying to guess what everyone else in the market is thinking. They’re trying to outguess themselves.
Of course, the difference between investing and a beauty contest, is that investing is always taking a chance on a future outcome. It’s more like a beauty contest where all the contestants are not yet born!
The best-kept secrets don’t stay best-kept for long.
Anytime an inefficiency presents itself, it gets arbitraged away by others who have figured it out. For example, let’s imagine you discovered you could purchase a $1,000 washing machine from Sears for just $500, and then sell it on Craigslist for $1,000 to earn a hefty profit. Good for you, but the good fortune won’t last long.
Either Sears will figure out they’ve mispriced and increase it to the $1,000 — or the people on Craigslist will eventually figure out they’re paying too much. Market supply and demand are the real drivers.
This analogy applies to any scale, even the scale of the stock market. The more people who participate, the more quickly an advantage disappears. Inefficiencies, at least for easy-to-value assets, tend to get worked out.
We can’t outsmart the market. But we can take a smart approach.
Before you dig your head in the sand and stick your money under your mattress, take heart. “Beating the market” may not be a reasonable goal, but we can invest with intelligence and take a smart approach over the long term. Building wealth is like running a marathon: you have to stay the course and it’s not going to happen overnight. In times of market dips and market spikes, don’t be reactionary. Be realistic about how aggressive or conservative your investments should be. And no matter how your portfolio performs, focus on cultivating contentment and finding your identity in more than your net worth.
If you’re looking for sound guidance based on timeless principles, we’re here to help. Contact the Sound Stewardship team for a complimentary consultation.
< Back to Updates
