Is there any empirical evidence that it is possible to beat the market?

Factual Questions
1

OK, when I say empirical, I don’t want to hear people’s anecdotes, since as we all know, anecdotes <> evidence.

Everything I’ve ever read indicates that over a long enough time horizon, the probability of beating market consistently drops to about zero.

Now there are a couple ways of approaching this and I would regard either as acceptable. One is to look at annual returns and compare those to the market. Any year where you don’t beat breaks your streak. Another is to look at total return over some period of time and compare that to the market.

I’m mainly interested in the performance of mutual funds but will be happy to see evidence for hedge funds or other entities who deal primarily in liquid securities.

2

You seem to be setting the bar very low. Of course it is possible to beat the market consistently over any period of time you choose, just as it is possible to win the lottery. This does not say anything about the expected value of any investment strategy (or of buying lottery tickets).

3

Your point is well taken and I suppose I should have been clearer about the parameters.

I’m not talking about statistical outliers such as people who win the lottery 3 times. I would however be interested in seeing, for example, a distribution of fund managers beating their index at 5, 10 and 20 years. I would expect to see that trace out half of a bell curve. Any indication that this is not the case I would consider evidence for the thesis that it is in fact possible to beat the market.

I would also be interested in any empirical evidence showing precisely the opposite of the thesis I’ve presented. For example, there was a survey of day traders in the past few years I believe showing that per hour, they made less than minimum wage - on average.

4

In general, no. Most of the mutual fund industry for example is built upon a combinations of scams and false beliefs that that isn’t supported by theory, statistics, or real-world results. There isn’t much need for the actively managed mutual fund industry to exist at all except that there is huge money gained from the people that run it. The fact that they charge fees to investors for their “expert” picks is their Achilles heel. It almost always drags down returns in the long-term significantly. The whole industry could and should be replaced with passively managed funds like index funds that are very cheap to invest in and almost mirror market return by definition because that is what they are designed to do.

It is possible to beat the market through luck or some more elaborate strategies. There have been some medium-term successes from groups that apply massive computing power and math models to the market and make a fast gain from it. Those strategies aren’t available to normal investors however and the fact that they do it tends to make the strategy less effective over time because their trades have an impact on the system itself.

The only company that I know of that has really good evidence of consistently beating the market is Berkshire Hathaway run by the billionaire Warren Buffet. He uses a very unconventional value oriented strategy and often becomes actively involved with turning promising companies around however with real cash and people. He doesn’t just pick stocks.

5

Warren Buffet/Berkshire Hathaway may frequently beat the market, but only a minority (now, in this case a “minority” is in the 10s of billions of dollars!) of his/their assets is in publicly traded equities. The majority is invested in wholly owned companies such as (going by memory) GEICO, Dairy Queen, Benjamin Moore, etc. So he/they beat the market largely by investing outside of it.

6

That’s a good point. There are also a lot of restrictions on fund managers such as how much of the fund can be in one particular stock. That’s why I would be interested in ANY empirical evidence that tends to proof either the thesis or antithesis.

7

If anyone could beat the market, then very quickly whatever that person was doing would become the market. Their strategies, supercomputers, whatever don’t even need to be public: It wouldn’t take long for ordinary folks to latch onto the strategy of “do whatever so-and-so is doing”.

8

That is what I alluded to earlier. It does happen. There is a very lucrative Wall Street job market that hires Ph.D.'s front unrelated fields like math and physics to exploit raw data for fairly quick financial gain. It can work but it is like counting cards in Blackjack. Eventually it gets noticed and the market adapts to it so they have to come up with something new. It isn’t something that applies to the industry as a whole. There are other illegal methods like the Bernie Madoff Ponzi scheme or simple insider trading. You can use that successfully until you get caught which might work for a long time for an individual but not for funds that are open to the general public.

9

There are whole books on this subject, so it’s tough to say anything in a sentence.

However, Shagnasty’s point that information is fungible is important. A scheme that does beat the market over a period of time can be studied and replicated by others, and eventually the advantage given goes to zero.

However, what gets left out of the OP is that people don’t have to try to beat the market forever. People do close down their funds after a period of time and take the profits, just as they sell individual stocks and take the profits. You don’t even have to shut down at the top as long as your total net is positive.

Can you get rich off the market, however broadly you want to define that? Obviously some do. Can anyone beat the market with a scheme forever? There’s no evidence for that. But they’re not at all the same question. Since money is as fungible as information, profits from the market can be put into real estate or venture capital or investment in a cash cow or into gold or fine art or a million other things. Once you’re rich you can keep money flowing in for your lifetime, and rich people manifestly do that.

If you want a scheme for future riches without starting off rich, again, that’s a very different issue. There’s no reason to believe that everyone who became rich in the past would become rich if they had to start over today. Somebody certainly will. We just can’t predict who or why.

10

Last time I read an article about index funds I recall that only 20% of fund managers beat the market over their careers (I know that is a very vague reference.) Honestly though, that sounds about right.

The ones that beat it are almost entirely just the ones who are on the fortunate side of the curve. I don’t believe that any active management strategy will consistently beat the market by “normal” investing. The way persons beat the market “consistently” is by knowing information not known to the public at large (illegally) or by doing something other than playing the market.

Warren Buffet’s returns are better than public stock market returns over his career, but he doesn’t beat the market by playing the market better than everyone else. As has already been mentioned, he doesn’t move stocks around and constantly play with a fund’s asset allocation in some pseudoscientific approach. He researches solid companies, often times privately held, and buys a massive controlling stake in them. He then mostly leaves the already successful company to run itself, but will of course exert some influence to protect his investment. That is so insanely far removed from me or you picking a basket of stocks to invest in and then modifying it over time in order to “beat the market” that they aren’t even worth comparing.

But even Warren Buffet, if all he did was pick stocks and invest in the public stock market, would almost certainly not be significantly out performing the market over his career. But that’s not how he made his money, and he has significantly out performed the market by doing what he does, but it isn’t playing the market.

That’s what people really mean when they say you can’t beat the market: overall, you won’t beat the market by investing in the market. Ideally your investment will grow as much as the market grows, and these days you can insure that with an index fund. (That’s still a nice rate of growth.)

If you realistically want 30%+ return on investment you need to basically be an entrepreneur or get extremely lucky. Many successful entrepreneurs have attained a better than market return on their investment over their careers; but not by “beating the market” but rather by running a successful business.

11

The trick there is that you don’t have to be able to beat the market to make money; you just have to make people think that you can beat the market. A lot of people will see “ooh, physics PhDs, they must be really smart, ooh shiny!”, and be willing to pay fees for those folks to manage money for them, but really, they’re not miracle workers either.

12

That’s a trick that only works until the bubble bursts. The physics gurus were actually a couple of generations ago in market terms. It was true for a while, but the current recession wasn’t really due to them or their theories.

The last recession was all about bankers figuring out new ways to dangle bright shiny “no risk” bundles in front of the suckers. Didn’t need physics for that.

13

You do have a point. The people that play those games don’t generally share what they are doing. However, there are people that put millions of dollars in their hands to let them try. Then again, the mutual fund industry is many times bigger than that so it could be based on a false premise and a few lucky results as well. It is hard to tell.

The psychological key to the stock market is that is usually a positive sum game so most people walk away happy with what they think they achieved if they do it long enough. The gambling industry runs a negative sum game for the players and they still manage to keep people coming back so it isn’t that hard to achieve that goal in comparison.

There is a whole body of knowledge on this subject when it comes to individual perceptions. If I took $1,000,000 from you and dropped it an index fund, you would probably be thrilled at the end of the year when I showed you a chart that I beat 75%+ of the mutual funds available to you and even happier after 5 years when I showed you that ‘my’ fund beat 98% of them.

What I won’t tell you is that all I did was cash your check and put it in an index fund and charged you several thousand dollars for that hour of service. You got screwed in one version of the story yet you made more money for yourself than the vast majority of people that invest in actively managed mutual funds so I did you a huge favor at the same time. That is the simple version of most of the investment industry except some of them are forced to play along in a game that won’t work the way it is designed as well.

14

Taking that as a generic “you”, sure. Of course, I already know about index funds myself, so I personally wouldn’t be thrilled by you charging me a fee of thousands of dollars for that service.

15

I described the whole game in plain language in my post. Most people don’t know or choose to think they can either pick better themselves or have the skills to pick the right people that can. That is why it exists.

BTW, if anyone is interested, I do have access to a firm that can beat 90% of available S&P mutual funds out there over a five year period guaranteed. There is a slight fee for investing in it but it is only open to readers of the SDMB board. You get all the market returns no matter what plus all fees refunded after five years if the promise isn’t met so there is no risk to you.

16

My recent audio book diet included Leonard Mlodinow’s The Drunkard’s Walk: How Randomness Rules Our Lives.

He covers the point by discussing, the most successful fund manager of the time. From the linked review:

*Nowhere is the attribution of genius and success more misleading than on Wall Street.

For 15 straight years, Bill Miller, portfolio manager of the Legg Mason Value Trust, outperformed the S&P 500. Money magazine showered Miller with accolades by calling him “the Greatest Money Manager of the 1990s.” Morningstar followed suit by naming Miller “Fund Manager of the Decade” and Smart Money magazine referred to him as one of the top 30 most influential people in investing from 2001 to 2006.

Mlodinow deconstructs Miller’s performance as a random streak and not rare genius. He writes: “There were more than 30 12-month periods during his streak in which he lost to the S&P’s weighted average, but they weren’t calendar years, and the streak was based on the intervals from January 1 to December 31.” In a sense, the streak was artificial to begin with and one that by chance was defined in a manner that worked to Miller’s favor. Given Miller’s recent fall from grace and subsequent market underperformance, the author’s point makes sense.*

It’s a great book by the way.

17

The simple answer to this question is probably not, but the answer is much harder to answer than that. A typical management fee for a mutual fund is 1% of assets per year. An appropriate question to ask is, how good does someone have to be to earn that? Well you’d have to beat the market by 1% obviously on average to just break even for your client.

How “right” do you have to be to beat the market by 1% on average? That depends on what you’re doing. Take a simple example. Suppose you’re a market timer, and you put all your money into the S&P when you think the market will go up by more than the interest rate and all your money into T-bills when you think market won’t? (It would be cheaper to use futures contracts, but don’t worry about that, this is a thought experiment)

If you are right 100% of the time, you essentially created an exactly at-the-money (in present value terms) call option. You get all the upside and never suffer the downside. But you created the option by being smart, not buy buying it so your knowledge is exactly as valuable as the call option.

Suppose you make your forecasts once a month. A one-month call on an index with volatility of 20% (about right on average for the S%P) at the money in Present value terms is worth, by the Black-Scholes model, 2.3% of the index value or 31.4% compounded over the year. So to earn your 1% per year, you’d have to be right 1/31.4 = 3.2% more of the time than random. That’s like saying you’d have to call a coin flip correctly 53.2% of the time.

Now suppose I claimed I was slightly psychic and could do just that. If we flipped a coin 100 times and I was right 54, would you believe me or think I was lucky? I assume you’d think I was lucky as a two-sigma event for a guesser would be getting 55 correct calls.

So if our market timer is just earning his fee, and called 54[sup]1[/sup] months correctly out of 100, you’d not necessarily think he was other than lucky either. In other words, it takes more than 8 years to ascertain whether a market timer is earning his money or not. That is a long time compared to most information we have about money managers.

If you want more details, look for “On Market Timing and Investment Performance” by Robert Merton www.people.hbs.edu/rmerton/OnMarketTimingPart1.pdf (obviously a pdf)

[sup]1[/sup] You have to be a little careful here as up months occur more than down months – our market coin isn’t a fair one with a 50-50 split, but the same idea works, you just have to adjust the math a bit.

18

It is an interesting question, as far as my experience goes, I agree that you can beat the market, but not consistently or steadily-there will always be times when the market is down, sometimes for years (like the years 1929-1937).
I also think that as any mutual fund grows (because of its superior performance), that fund has less and less chance of beating the market-simply because of its size.
Which leads to my question: for many years, the Fidelity Magellan Fund was (apparently) capable of returns beyong what the market averages provided. Suppose you were the manager of a smaller fund-and you were able to get inside information from the management of the Magellan fund. You could easily make short term gains by buying the stocks that Magellan was buying-and dumping/shorting the ones they sold. You could potentially outperform Magellan with this kind of (illegal) operation-I wonder how much of that goes on?

19

That’s not illegal and the strategy has been around for quite some time. Though, it is far from easy money. Around stock index addition/deletions and rebalancing days there are often huge order imbalances at the market close. Luckily, in the days leading up to these events index arbitrageurs and market makers usually accumulate and/or short stock so as to provide liquidity and offset imbalances, thus dampening volatility.

edit: To clarify, it’s not illegal to anticipate large orders and trade in front of them - index changes, etc. I’m unsure about the legality of trading ahead of a single fund’s trades.

20

One thing to consider is that the reason the market is so hard to beat is that so many people are trying to beat it. Or to say it another way: the market is determined by the people trying to beat it, both those who succeed and those who fail.

As an individual investor, it’s better to put your money in low-fee index funds. But as more people do that, the market becomes less competitive and easier to beat. The market does well because of all the people trying to beat it; the fewer that try, the less well the market will do in general. Thus, although it’s in my interest to keep my investments in low-fee index funds, it’s not in my interest to encourage others to do the same. It’s better for me that most people try to beat the market.

I had a discussion once with someone who was constantly looking for good stock picks and good fund managers. He wanted to beat the market and couldn’t understand why I invested in index funds. “You’ll always be stuck at the market.” I said, “Exactly!” :smiley: