Judging from the financial headlines, we live in a world where everyone sucks at investing.
Hedge funds? Consistent underperformers: this year, last year, the year before that, the year before that, the year before that. Every year, it seems. Just google “hedge funds” and “underperform”, to see the flurry of giddy articles that pop up.
Individual Investors? Again, consistent underperformers. They get excited at the tops, they panic at the bottoms, they do everything exactly backwards to the maximum extent possible. The published numbers here are quite ugly: according to Dalbar’s 2013 QAIB publication, the average individual equity fund investor has earned a pathetic 3.69% annualized return over the last 30 years, versus the S&P’s 11.11% (note: the QAIB report may contain distortions).
How is such consistent underperformance possible? The answer, we are told, is behavioral. Investors, of both the professional and the layman stripe, tend to herd. They prefer to do what everyone else is doing. And so they end up buying when assets are in high demand, at the worst possible prices, and selling when assets are out of favor, again at the worst possible prices.
There’s an obvious problem with this narrative, which you’ve probably already noticed. For every party in a trade, there is a counterparty–for every buyer, a seller, for every seller, a buyer. There must, then, be an outperforming counterparty to the underperforming average investor, and the undeperforming average hedge fund, and the underperforming average day trader, and the undeperforming average endowment, and whoever else underperforms on average. Someone had to be smartly selling to those groups in 2000 and 2007, for example, when they were frantically trying to get in, and smartly buying from them in 2003 and 2009, when they were desperately trying to get out. Who–what group–is that someone? And why doesn’t the financial media ever celebrate its achievements?
I’m glad to be able to tell you that I am a member of that group. Over the last 15 years, I have compounded my own capital at a 35.9% annual rate, profiting handsomely from the ill-timed and ill-advised decisions of “average” individual investors, mutual fund managers, and hedge fund managers alike. And don’t be fooled; it’s not just me. A lot of us do quite well, thankfully.
Of course, everything I just said is a bald-faced lie. So don’t worry. I’m not better at life than you. But how did it make you feel to read about someone else’s spectacular performance? Probably not very good. That’s why the media prefers the “everyone sucks” headline. It makes for fun, satisfying, ego-pleasing reading.
The truth is this. Investors in aggregate are the market. Before frictions (fees, transaction costs, etc.), they cannot underperform. Nor can they outperform. For they would be underperforming and outperforming themselves, and that is obviously impossible. Now, if we arbitrarily divide the market into different categories of participants–individual investors, hedge funds, pension funds, corporations, and so on–then it would be possible for some categories to consistently underperform others (note that this would create tension for the efficient market hypothesis–pure negative alpha is, in fact, a type of alpha). But, necessarily, the other categories would be outperforming.
What category of investor, then, is consistently outperforming the market, against the consistent underperformance of hedge funds, individual investors, and other losers? You will be hard pressed to find an answer. An obvious candidate would be the corporate sector, which has, in recent years, taken large amounts of equity out of the market through share buybacks and acquisitions, effectively forcing the rest of the market to be net sellers. The problem with citing corporations as the clever counterparties, however, is that corporate managers exhibit the same herding tendencies as the rest of the market. According to Z.1 data, they too prefer to buy high and sell low, having bought heavily around the 2000 and 2007 peaks, and having sold at the 2003 and 2009 troughs.
Part of the problem here is that we arbitrarily treat the S&P 500 as “the market”, the benchmark for evaluating performance. But the S&P 500 is not a reasonable benchmark to use, since investors in aggregate do not allocate the entirety of their portfolios to U.S. equities. Indeed, investors in aggregate cannot allocate the entirety of their portfolios to U.S. equities–if they tried, prices would go to infinity. The strategy of devoting an entire portfolio to U.S. equities, which may look brilliant right now given the recent performance, would necessarily become a bad idea (if it isn’t already a bad idea).
The appropriate benchmark for performance evaluation is the global asset market, which includes all global assets: stocks from all countries, bonds from all countries, real estate in all countries, and, importantly, cash from all countries (commercial paper, government bills, bank deposits, and so on). Over the long-term, some groups will surely outperform this market. If the efficient market hypothesis is true, we should expect it to be those groups that choose to accept the most risk in the choice of what they own. If the efficient market hypothesis is not true, then we should expect it to also include those groups that possess skill, that manage to own the right assets at the right prices at the right times.
Similarly, some groups will surely underperform the global asset market, because those groups choose to take on less risk than the global asset portfolio contains (making it possible for other groups to take on more risk), because those groups lack skill (making it possible for other groups to demonstrate skill), or because those groups stupidly accept unnecessary frictions–management fees uncompensated by skill, overtrading with high commission costs across large bid-ask spreads, and so on (making it possible for financial middlemen to earn a living). But the point is, with performance properly measured, it’s not possible for everyone to consistently underperform. Not everyone sucks at investing.