Sunday, December 30, 2012

Can Individual Investors Beat the Pros?

            Individual investors clearly do not have the resources to match the trading expertise of sophisticated institutions and hedge funds.  Nor do they have access to the automated trading systems that continually scan the markets and trade in time frames approaching microseconds.  It is not surprising, therefore, that many individual investors, and many pundits as well, have concluded that the best course of action for individuals is to put money into one of the sophisticated funds or go home. In their view, it is no longer possible for individuals to compete effectively in the modern market place.
Such views, though intuitively appealing, turn out to be 180 degrees wrong.  If individual investors accept their limitations and act wisely, they will always outperform active professional investors in the aggregate!  Furthermore, this surprising conclusion does not depend on complex economic arguments regarding market efficiency or market rationality.  Nobel Prize winner William Sharpe has shown that it is a direct result of basic arithmetic.  A simple example illustrates how it works.
            Take all stock market investors and divide them into two groups – passive and active.  The passive group is composed of individual investors who conclude that they do not possess the information nor the skills to compete with active professional investors.  These passive investors buy an index fund designed to match movements in the market as a whole.  Such funds are available at very low cost because no active management is required.  The active group consists of everyone else, but is composed primarily of active professional investors. 
            Now suppose in any given year the market rises by say, 10%.  The index fund, by construction, matches the market so passive individual investors earn 10%.  But if the market goes up 10%, and the passive group earns 10%, the active group must also earn 10% because the market consists of active and passive investors.  For the active investors, however, this 10% is before expenses.  Active investing is expensive whether it is due to designing and implementing costly computers systems or hiring sophisticated traders and analysts (remember they get paid millions).  When these expenses are netted out, the active group as a whole must earn less than 10%.  In other words, the “professionals” as a group must always underperform passive individual investors as a group.  This is true whether the market rises or falls and whether the market is responding rationally or emotionally.  The passive group, as a group, must always outperform the active group, after expenses.
            It should be stressed that the foregoing conclusion holds on a group-wide basis.  Within the group of active investors, some will most likely have done much better than 10% and others much worse.  But as a group, after expenses, they must have earned less than 10%. 
            What Professor Sharpe’s analysis makes clear is that the real threat to the individual investor is not being in the market, it is actively playing the market.  Small investors who passively hold the market can be assured that they will outperform active investors overall.  However, should they decide to become active themselves, all bets are off.


R W said...

I remember this from your class. Great example and glad I am a long term investor.

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