Outsmarting Wall Street
Over the last 20 years, an increasing number of individual investors have figured out how to outsmart Wall Street. How are they doing it? More importantly, how can we increase our odds of winning the investment game?
To understand how these investors have beat Wall Street, we must first understand what Wall Street wants you to believe.
"I Won't Be Bamboozled!" (Wanna bet?)
It's almost impossible to win Three Card Monte. Even though most people know it's a scam, they still believe they can win, thanks to the mother of all psychological biases, overconfidence. Overconfidence bias is our natural tendency to feel more confident in our own abilities than we actually are. And like most psychological biases, it's powerful. All of us can be susceptible to it. (If you disagree, see if you can beat me at Three Card Monte.)
Wall Street is Kind of Like the Three Card Monte Dealer
Sometimes investors think they can beat Wall Street because they have (A.) Confidence in their own ability to pick winning stocks or (B.) Confidence in someone else's ability to pick winning stocks for them. Either way, Wall Street usually wins. You’ll either attempt it on your own and most likely become their victim, or you’ll pay them high fees in the belief that they’ll beat the benchmarks for you. It is not in their interest to recommend passive strategies like low-cost index funds. It doesn't pay off for them. Even the media know recommending passive strategies doesn’t sell newspapers or airtime. Until about 20 years ago, most retail investors (like you and me) were paying someone to use active strategies, or they were using active strategies themselves. But the tide is turning. The number of professional managers who outperform is shrinking as more investors are moving away from active management (stock-picking and market-timing) and into passive index funds. How are these investors doing? I'll get to that in a moment.
Why It’s Almost Impossible to Outsmart the Dealer
When you buy a stock because you think it's a great deal, you are saying, “I am right about this stock, while most investors are wrong.” In other words, you’re saying that the price investors choose to transact at is too low. That's the definition of overconfidence bias. And like the Three Card Monte dealer, it's exactly what the media and Wall Street want you to believe. Here’s why:
Who determines the price of a stock? Answer: Investors, collectively. Who are these “investors”? For the U.S. stock market, they are institutional investors like hedge funds, high-speed traders, and large portfolio managers. This group of professional investors executes 90 percent of all trades. They have more knowledge, capacity, and resources than we have as individual investors to determine a stock’s price. So, if you are picking stocks, you are saying, “I think the consensus of these professional institutional managers is wrong. I can beat the dealer."
Some might point out the consensus often is wrong, after all, stocks can be mispriced. This is true. But that still leaves the same questions: Do we have the skill to identify those mispriced stocks? What information do we have that these institutional managers somehow missed? The deck seems stacked against us.
The Gullible Victim
Again, institutional managers execute the vast, vast majority of trades. This means they are mostly trading with, and competing against, one other. The exponential increase of professional managers over the last two decades makes it tougher for them to generate outperformance. There are now more professional money managers than there are stocks on the New York Stock Exchange. So active managers need victims they can exploit, and that usually means retail investors (like individuals picking stocks). The research indicates on average active retail investors underperform their benchmarks, so naturally they are easy prey for Wall Street. Yet many investors keep stepping up to the table, ready to throw their money down, confident they can beat the dealer.
Is the Public is Catching On?
Fortunately, the trend has been shifting slowly over the last 15-20 years as more and more investors have been moving away from active strategies and into index funds. The public is starting to realize the best way to beat Wall Street may be to deprive them of victims. That is, refuse to play their game. Instead of picking stocks or trying to time the market, it may be wiser to invest in a globally diversified portfolio consisting of low-cost index funds or asset-class funds, and then holding on for the long-term. How is that strategy working out? Every year, S&P Dow Jones Indices does a study on active versus passive management. Last year, they found that after 10 years, 85 percent of large-cap funds underperformed the S&P 500, and after 20 years, nearly 94 percent are trailing the index. In other words, active management outperformed the index only 8 percent of the time. Those are some pretty terrible odds! Investors who simply bought the index beat 92 percent of active managers who were picking stocks or timing the market.
Can You Win the Game?
In their new book, The Incredible Shrinking Alpha, Larry Swedroe and Andrew Berkin contend that “Stock picking has a terrible track record, and it’s getting worse.” Swedroe recommends investors have a written investment plan tailored to their individual ability to tolerate risk. He suggests that most investors are better served owning low-cost index funds and not bothering to pay an active manager a higher fee to pick stocks or funds. Then stay the course, ignoring the noise of the market and the media, and rebalance along the way. Additionally, becoming more educated and aware of your natural human biases, such as overconfidence bias and hindsight bias, can help protect you from your biggest enemy as an investor: Yourself.
If you want to outsmart Wall Street, your best odds may be to avoid picking stocks and avoid trying to figure out the best time to get in or out of the market, and instead, use a more academic approach. Investing this way may not seem exciting. But if you want excitement, you may be better off playing Three Card Monte. And the only way I'm aware of to win Three Card Monte, is to learn how the game works, and then deal the cards yourself.