Just Say No to Active Investing: Part 2
This is the second part in my 3-part series on why I actively invest $0 in my portfolio. You can navigate between the sections below:
Just Say No to Active Investing: Part 1
A Very Short History of Investing in the US
Why Humans Are Really Bad at Active Investing
Just Say No to Active Investing: Part 2
The Efficient Market Hypothesis
Most Personal Finance Advice is Actually Just Active Investing
In part 1, I made the point that almost nobody has the requisite experience to become a really good active investor. I also outlined 4 of the most impactful cognitive biases that make it difficult to make rational investing choices.
In part two, I’ll go deep on the Efficient Market Hypothesis (EMH), why I think a loose interpretation accurately describes markets today. I’ll also clarify why I think most personal financial advice is basically just stock picking.
The Efficient Market Hypothesis (EMH)
Up to this point, I hope I’ve been able to convince you of two things: only a vanishingly small number of people throughout history have actually gotten good at investing and we humans are pretty bad at thinking rationally about investing.
In this section, I hope to convince you that on average and over the long run, large markets for assets operate with at least weak efficiency. This idea is known as the Efficient Market Hypothesis. Although it has been widely researched and analyzed, it remains contentious. Here’s the crux of the efficient market hypothesis stated in its strongest form:
“Share prices reflect all information and consistent alpha generation is impossible.”
Interpreting that a bit for non-finance types, what this means is that the share price of any stock in a large market already reflects everything that everyone in the market knows about the value of that stock.
This seems to be at least anecdotally plausible. There are many millions of banks, traders, and algorithms that constantly trade stocks on the major international exchanges. Apart from insider trading, which is illegal, every person in the market will use the information available to them. There is essentially infinite money to be made if you have an information advantage. Not surprisingly, there is an a very strong incentive for all information to be priced in.
The OverthinkingMoney EMH Restatement
If I’m being honest, I think this strict formulation of the EMH is pretty ridiculous. It seems patently obvious that markets are a lot less efficient than the experts would have us believe. Not all information is accounted for. Not every market participant has the money to vote with their dollars. And entrenched interests distort the efficient operation of the market to make it easier for the rich to get richer.
But I think if you can soften some of the assumptions and get to a pretty reasonable theory. Here’s the OverthinkingMoney restatement of the EMH:
But What About Star Investors Like Buffett?
The OM version of the EMH actually doesn’t make any statements about individual returns. There will always be outliers. In fact, the OM version of the EMH basically requires that some investors earn returns that beat the market average. The market average is – definitionally – an average of the returns of people operating in that market. So at any given time, some investors must be winning relative to the market average and some must be losing.
What’s really unintuitive about the EMH is how long it permits winners to win and losers to lose. There is no magic number for how long you can win. The EMH just predicts that given long periods of time, your returns are increasingly likely to converge on the market average.
Your friend who made $5M on some crazy trades 3 years ago isn’t evidence that the EMH doesn’t work. There will always be people who get lucky. There will always be a very, very, very small number of people capable of beating the market year in and year out. A large number of active traders can masquerade as those market-beating long-timers in the short term. But the OM EMH states that if you wait long enough, most eventually lose big.
Why Can’t You Generate Above-Market-Returns Over the Long Term?
The EMH predicts that profitable information advantages cannot be kept secret over long periods of time. This is counter-intuitive. If you figure out a trading strategy that generates large profits consistently, why not just keep it to yourself! That’s easier said than done.
Let’s say that you develop a trading algorithm that reliably generates profit with every trade. It’s a literal money-printing machine. Being a smart investor, you make it very difficult to track your activities. Just to be extra-careful, you dedicate yourself to never spending any of the money you earn.
Even then, someone somewhere will eventually figure out that you have an enormously profitable secret. Maybe it will be someone at the brokerage house that discovers your newfound success. Maybe it will be a mathematical savant on WallStreet Bets that figures it out. All they would have to do is identify some of your trades and mimic them for your advantage to start evaporating.
ETFs would spring up that copy your trades. Investors would pile in to take advantage of the free profit. At every step, the profit you can realize from each trade would decline. At first, you might be able to make $0.10 per trade. In short order, though, the information you used to generate profit would be “priced in” to the market. Each of your trades would generate $0 in profit and the money spigot would turn off.
What Does the Data Say About the EMH?
Whether or not you believe that the EMH actually functions in its strong or OverthinkingMoney variants, there is compelling evidence that individual stock pickers cannot consistently beat passive funds:
- Early research done by Alfred Cowles in the 1930s and 1940s suggested that active investors were unable to outperform the market in general [source].
- According to Morningstar, less than 25% of active stock pickers can beat passive funds over time [source].
- A 2022 study that found that of 2,132 actively managed stock and bond funds, none outperformed the market regularly over the past 5 years [source].
- A 2019 study by David Nanigian found that between 1991 and 2018, there was no practical difference in returns between passive and active funds [source].
- According to the S&P and Dow Jones as of 12/31/22, the percentage of US equity funds that underperform the S&P 500 is >80% over a 3 year period and rises to 97% over a 20-year period [source].
What Do Successful Investors Think of the EMH?
- Warren Buffett’s business partner Charlie Munger has stated that the EMH is “obviously roughly correct” and that it’s “quite hard for anybody to [consistently] beat the market by significant margins” [source].
- Joel Tillinghast, a fund manager at Fidelity who has consistently outperformed the market thinks that the core arguments of the EMH are “more true than not.” He believes in a “sloppy” version of the theory which allows for a margin of error [source].
- Nobel prize-winning economist Paul Samuelson has argued that the market is “micro efficient” but not “macro efficient.”
What emerges from studies and anecdotes is a fuzzy agreement that in general, it’s very hard to beat the market, but not impossible. This confirms the Overthinking Money Efficient Market Hypothesis that you are theoretically capable of beating the market, but very unlikely to do so for any sustained period of time.
The Big Reason to Care About Little Fees In Active Investing
One of the primary reasons that the Efficient Market Hypothesis appears to hold up over the long term is that active funds are expensive. Fund management fees seem small, but they aren’t when counted over the long-term.
To prove the point, consider a scenario in which you start with $100,000 that you want to invest. You have identified two funds that look promising: the Vanguard 500 index fund and the second-largest actively managed mutual fund, American Funds Washington Mutual Investors Class 529-C.
The Vanguard 500 index fund has a yearly management fee of .04%. The American Funds mutual fund has a yearly management fee of 1.4%. Here’s how your investment would fare over 30 years, assuming a 5% rate of return:
So a seemingly-small fee (1.4% per year) adds up dramatically over time. Of course, you would hope that the actively managed fund would out-perform the market. But to do that, the manager would need to at least beat the market by at least 1.36% per year. Considering that only 3% of actively managed funds manage to do that over 20 years – let alone 30 – it seems like a pretty bad bet.
And what if the actively-managed fund doesn’t outperform the market? You will have effectively paid a fund manager who likely doesn’t know your name $139,000 of your hard-earned cash to make up theories, white papers, and presentations about why their investing strategy will definitely beat the market one of these days. Ouch.
Most Personal Finance Advice is Just Active Investing in Disguise
Up to this point, I’ve been talking about active investing in the context of stock and bonds. There’s a certain mental association that works well here. You can easily picture Michael Douglas as Gordon Gecko in his suspenders yelling into phones in a Manhattan highrise, wheeling and dealing and living the high life. You might think “good thing I don’t buy into that Wall Street tripe about active investing returns.” But at the end of the day, most personal finance advice is exactly the same thing. Let me explain.
Any time you invest a sizable portion of your money into a single, discrete asset, you are essentially picking stocks. True, the thing you own may not be called a stock, but your purchasing criteria and expectations are the same. You do some research and decide that the rental property around the corner is a good deal. So you buy it with the expectation that it will generate rental income and eventually be worth more than you paid. You could substitute “dividend stock” in place of “rental property” and your market hypothesis would be the same.
This applies to almost every commonly-discussed asset. Real estate, land, cryptocurrencies, web3 goods, art, shares in a startup, domain names, exotic cars, jewelry, and precious metals all behave like individual stocks. The next time you read a post about how you can make $50,000 a year buying and selling domain names, just picture Gordon Gecko and think “how much do I trust this person?”
Be on the Lookout for Financial Influencers and Their Active Investing Schemes
One really common pattern of hucksterism in personal finance is hawking the newest, shiniest tech invention and claiming that it’s different from all the other boring assets that have come before. Cryptocurrencies, NFTs, and VR homes are recent examples of this. They seem just different enough from the mundane assets they imitate (money, art, and homes) that credulous people desperate for returns can be tricked into thinking this is their million dollar ticket. It turns out that it’s much easier to monetize attention than it is to be a truly successful active investor.
What’s Next?
Follow along for part 3 in which I cover the topic that you probably wish I had started with: how to actually realize solid returns as an active investor and why I think it’s morally superior to be a passive investor.
Happy overthinking!
• According to the S&P and Dow Jones as of 12/31/22, the percentage of US equity funds that underperform the S&P 1500 is >80% over a 3 year period and rises to 97% over a 20-year period [source].
Shouldn’t that be S&P 500? Not 1500.
• “Nobel prize-winning economist Paul Samuelson has argued that the market is “micro efficient” but not “macro efficient.”
What does Samuelson mean?
Yeah, thanks for catching that. Fixed the typo!
My interpretation is that Samuelson is saying that if you only look at the level of how a stock responds to some small information disclosure, say a quarterly earnings report, that the price fully incorporates all there is to know about the business. But that if you consider the much broader context in which a company operates, the price is unlikely to fully reflect the value of the stock.
For instance, an energy stock might jump 10% after an earnings call, but in a couple of months drop 50% after it becomes clear that climate change mitigations will cause the company to bleed money for the foreseeable future. Someone who believes in a macro-efficient market would say “that 50% was priced in because there was always a risk that something like that would happen to petroleum companies,” but Samuelson is saying that most investors aren’t reacting to big, uncertain macro trends, only quantifiable micro-trends.