• Marc

Is Your Crystal Ball Consistently Foggy?


Many believe investing is a science, others think it is a timing game; however, studies show that it is similar to receiving answers from a faulty Crystal Ball—one that is more often than not incorrect. The main goal amongst investors, hedge fund managers, and stock pickers is ultimately to outperform the market. This, of course, can be done by mainly 2 endeavors, namely active stock picking or active market timing. Both endeavors are a bet on future behavior of an individual stock or the market in general and hence, can be likened to looking into a Crystal Ball in the hope to foresee the future. However, much to investors’ chagrin, they are playing a losing game when performing either of these fruitless endeavors. Statistically speaking, and supported with data, it is next to impossible to outperform the market on a consistent basis. In fact, the longer an individual participates in trying to outfox the market, the less likely he is to succeed in his dreams to outperform the market.

Still think well recognized professionals have the key to investment success? Let’s have a look at the ultimate professionals in actively managing your money by stock picking and market timing, i.e. professional money managers working for actively managed mutual funds. After all, they consistently get paid multi-million dollar bonuses for their alleged ability to outperform the market, hence wouldn’t it be a good idea to test if they really are worth their salt at all? According to SPIVA (S&P Indices Versus Active), over a 5-year period 91.91% of actively managed funds in the US and 79.93% of actively managed funds in Europe, underperform the market—providing hard evidence that an actively managed fund is more likely than not to fail at the goal of outperforming the market.

With a majority of fund managers consistently underperforming, there seems to be little hope of success in this game. The S&P Persistence Scorecard revealed that out of 631 domestic equity funds in the US that were in the top quartile as of September 2014, only 2.85% stayed in the top quartile at the end of September 2016. Meaning that only 2.85% were able to consistently perform well, making matters even more dismal. Thinking you should act now and get more involved in your portfolio? Well, an interesting find within the S&P Persistence Scorecard is that most funds found within the fourth quartile are those funds which exercised the highest percentage of style change, illustrating that the poorest and least consistent performing funds were those which were managed most actively. Thus, while it may not be entirely impossible to consistently perform well, it is proven to be highly unlikely. And these poor statistics get even worse the longer the holding period under consideration by SPIVA.

So why is investing success so difficult to attain and why are only so very few funds able to outperform the market, you might ask? The answer is provided by Nobel Laureate and founder of Modern Portfolio Theory, William Sharpe. Sharpe shows in his publication, “Likely Gains from Market Timing”, that the problem with catching inefficiencies in the market is that they are almost always recognized only after the fact. Sharpe also noted that gains of little more than 4% per year achieved though market timing would be expected from a “prophetic” individual, one who correctly guesses accurately more often than not—maybe one with a true crystal ball perhaps. With the average market timer only holding about a 50% accuracy level, and managers correctly predicting poor investment years only around 10% of the time, it does not seem likely that market timing is the way forward. In order to achieve gains after fees through market timing, an individual would have to have an accuracy score significantly above about 70%, according to Sharpe, a feat shown to be virtually impossible.

So you still think you or your fund manager has what it takes to correctly time the market? Well, further evidence can be found through CXO Advisory, a research outlet which tracks public forecasts of self-proclaimed market-timing gurus and rates their accuracy by assigning “guru grades” as “correct”, “indecisive” and “incorrect”. The highest accuracy an individual has achieved is 66.40%, demonstrably higher than the average stock market forecasting accuracy rate of 50%--the same accuracy rate of calling the flip of a coin. This 68.4%, the highest accuracy achieved, is still well below the accuracy required to actually experience gains once trading fees are taken into account.

Now that you may be doubting your money manager as well as your own ability to correctly time the market, let’s take a final look and see if you can at least rely on investment newsletters. According to a study done by the National Bureau of Economic Research (NBER), out of 237 investment newsletters from 1980 to 1992, few existed more than 4 years and on average, all underperformed the average buy-and-hold portfolio as well as the average investment portfolio. Thus, the results are indeed bleak and you are best advised to cancel all of your stock newsletter subscriptions since such newsletters cannot aid you in your journey to correctly market time.

As a whole, it is unlikely that seeking to “outfox the market” on a consistent basis will come to fruition for the common investor; however, those funds which are most likely to consistently perform well, and in the top quartiles, are those which are impervious to human emotional action—such as index funds which are based on rules-based investment mandates and typically follow indexes without human intervention.

As Vanguard’s Founder, John Bogle, states in a now famous interview given to Money Magazine in the heat of the 2008 financial crisis: "Sure, it'd be great to get out of stocks at the high and jump back in at the low, and if you know how to do that, then do that. But I've been in this business 55 years and I don't have any idea how to do it. In 55 years in the business, I not only have never met anybody who knew how to do it, I've never met anybody who had met anybody who knew how to do it. "

Nobody could have summed up the state of affairs of market outperformance any better!

Sources:

http://us.spindices.com/spiva/#/reports

https://www.cxoadvisory.com/

http://us.spindices.com/documents/spiva/persistence-scorecard-december-2016.pdf?force_download=true

http://www.crsp.com/

http://open.bu.edu/bitstream/handle/2144/17732/Javadekar_bu_0017E_12086.pdf?sequence=1&isAllowed=y

http://www.cfapubs.org/doi/abs/10.2469/faj.v31.n2.60?journalCode=faj

http://money.cnn.com/galleries/2008/pf/0804/gallery.expert_opinions.moneymag/12.html

http://www.nber.org/papers/w4890.pdf


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