Does your investment portfolio generate returns that are higher than the stock and bond market averages? Don’t feel bad if the answer is no. Even financial professionals find it extremely difficult to produce better returns than the market averages on any sustained basis. In fact, the pros usually fall short even though they spend their working hours trying to outsmart the market.
An overwhelming amount of academic research indicates that the majority of investors, whether they are professional or not, can’t consistently beat the market averages over long periods of time. And for the ones who do, it’s very difficult to tell whether they are lucky or skillful. What you see below is a fascinating chart of actively managed stock mutual fund categories that illustrates this phenomenon. All of the fund types except one failed to outperform their respective benchmarks for the five-year period ending December 2012.
It is also difficult to capture outsized returns in the bond markets. Persuasive academic research provides evidence that the bond markets are efficient and that interest rates and bond prices do not move predictably. Check out this chart:
If the time period had been extended beyond five years, even fewer stock and bond managers would have beaten their benchmarks
Fees and expenses represent a daunting hurdle. These costs have to be subtracted from mutual fund returns because investors must pay them. (You may not be aware of your mutual fund fees because fund returns are directly reduced by them.)
The efficient market hypothesis provides the other piece to this puzzle. This hypothesis suggests that stocks trade at or very close to their fair value based on the collective wisdom of the entire stock investing community. Consequently it’s unlikely that a sole investor, whether he or she is a money manager or an average Joe, could know more than everyone else (and know more on a sustained basis). According to the hypothesis, those who fare better are just lucky.
If you believe as we do that attempting to outsmart the market isn’t the most attractive option, then your best move will be to invest in low-cost index or passively-managed funds. You will learn more about index funds in a future post.