October 22, 2020

Investing Principle #7: If You Can’t Beat the Market, Then Own the Market

It isn’t easy to beat the stock market.

In fact, most money managers typically underperform. And those who are able to beat the market one year struggle to stay on top in subsequent years.

Why? Turns out that outperforming the market may be more about luck than skill.

Imagine a baseball stadium filled with 20,000 fans (pre-COVID days). You give each fan a quarter and ask them all to flip the quarter at the same time. If the person flips a heads, they get to stay. If it’s tails, the person must leave the stadium. Because the odd of heads or tails is 50/50, after the first flip about 10,000 fans will stay and 10,000 will leave. The remaining fans flip again and 5,000 will stay and 5,000 will leave.

After a total of 14 flips, the odds are that only one person will be left, having managed to flip 14 heads in a row. Now fill the stadium back up. Would you expect the same person to flip 14 heads in a row? Probably not.

A great stock picker is like a great quarter flipper.

It is mostly about luck. In fact, studies have found that active managers as a group do worse than random chance. Meaning they might actually improve their stock picking performance if they used coin flips to make stock picks.

Since trying to beat the stock market leads to a high probability of underperformance, most investors would be better off simply just owning the market.