Why Pros Can’t Beat the Market, but You Can

A small part of my investment portfolio is an index fund tracking “the market”, and apparently I’m not alone.

Over the past few years trillions of dollars have flowed into index funds as people realize highly paid professional money managers seldom beat the market.

Bill Mann, after spending eight years running active funds, explained why that’s a difficult task:

“Fund managers are under pressure to be predictable by showing low tracking error, which essentially means funds have to try to beat their benchmarks while tracking their benchmarks closely. Does that remotely make sense?”

To say that another way, fund managers become “closet indexers.”

For instance, if they say their benchmark is the S&P 500 they need to assemble a portfolio of stocks that closely resembles the S&P 500 because if their fund underperforms its benchmark investors pull their money out.

And that’s the game fund managers are playing, to attract and keep the most money, because fees are percentage based. The fund with $10 billion under management rakes in more than the $3 billion one.

But here’s what took me years to realize: saying that professional money managers can’t beat the market has absolutely nothing to do with what you can or can’t do.

Please, read that again.

Here’s why small-time investors like you and me have an enormous advantage over any professional.

1. You’re a speedboat, they’re a battleship. You’re investing small amounts of money, not many hundreds of millions or billions. What do you think happens when a fund manager finds an underpriced stock and starts buying millions worth? It causes the price to go up, and there goes the advantage.

2. No one’s looking over your shoulder. Fund managers have bosses breathing down their neck, making sure they’re tracking their benchmark, to prevent withdrawals. It’s the old, “Nobody ever got fired for investing in IBM Apple” syndrome. It’s very hard to get market-beating results when you’re forced to invest conventionally.

3. You didn’t study investing. The smart people with MBAs who study modern portfolio theory and understand those squiggly lines on technical charts have been conditioned to believe investing can be broken down into some science like engineering or physics, so neat and tidy. Nope, it can’t. Markets involve messy people.

While anyone can pick stocks, trying to beat the market, that doesn’t mean everyone should. Stocks take a certain skill set I’ve outlined before, and it helps to have help, which is why I use Motley Fool Stock Advisor.

Speaking of them, there’s no question their stock picking method beats the market, because they’re picking better than average stocks. From their website, as of today:

5 year return: up 60%, S&P 500 up 37%
17 year return: up 382%, S&P 500 up 91%

Over the past five years they’ve beaten the market by 23%, and so if you’re interested in picking stocks it might be as simple as buying and holding their latest recommendations for years to come.

Sure, you’ll get some picks wrong, and that’s okay. The idea is your winners will more than make up for the losers, and I know because I’ve picked some duds but my returns still beat the market. This is similar to how Jeff Bezos thinks:

“We’ve made doozies like the Fire phone and many other things that just didn’t work out. We don’t have enough time to list all of our failed experiments, but the big winners pay for thousands of failed experiments.”

Anyways, one of the most phenomenal small-time investors I know is Saul Rosenthal. He’s been compounding money at 30% or so for 30-some years, but also works harder at it than anyone. He currently owns nine stocks, only his very best ideas, and always thinks deeply about them, trying to find his blind spots.

You might think having your life savings in nine stocks is nuts, but I’ve learned it’s better to have a small portfolio where you know a lot about a few companies than some gigantic portfolio where you know little about lots. I’ve trimmed my portfolio to 15 stocks and that index fund. It feels good.

Of course, running a concentrated portfolio like that takes more work. (When all your eggs are in one basket you watch that basket.) But if you find the work enjoyable, like it’s a game for you, the results can be life changing.

Does all this make sense?

I bet you’ll always hear things like, “If professional money managers can’t beat the market, with their huge budgets and computing resources, then neither can you.”

Again, just because they can’t beat the market has absolutely nothing to do with what you can or can’t do. Value investor Mohnish Pabrai said it best:

“Investing is a peculiar business. The larger one gets, the worse one is likely to do. So this is a field where the individual investor has a huge legup on the professionals and large investors.”

It’s a mathematical fact some people picking stocks, trading in and out based on headlines or feelings, will do worse than the market. This is because investing is a zero sum game. In order to earn more than the market you need to take money from someone else, and many small-time investors do just that.