“My basic point here is that neither the Financial Analysts as a whole nor the investment funds as a whole can expect to ‘beat the market,’ because in a significant sense they (or you) are the market . . . the greater the overall influence of Financial Analysts on investment and speculative decisions the less becomes the mathematical possibility of the overall results being better than the market’s.” — Benjamin Graham
A principle that continues to be true in finance is that the solutions of the past often create the problems of the future. This was exemplified by the Securities Act of 1933 and the Securities Exchange Act of 1934, which mandated financial disclosures and banned market manipulation and insider trading. Prior to these acts, stock operators on Wall Street cheated the markets rather than outsmarting them.
These regulations were necessary to clean up the securities markets, making skillful analysis the primary way to beat the market. However, truly exceptional securities analysis has always been rare.
Despite this, capital continues to flow into actively managed mutual funds, even after index funds were introduced in the 1970s. Fund managers introduced various strategies to differentiate themselves and convince the public that they could add value beyond what index funds offer. However, the average managed portfolio underperformed broad indexes even before fees, as shown by a 1940 study by the SEC.
For over 80 years, evidence from government agencies, Nobel laureates, and experienced practitioners has demonstrated that very few active managers consistently outperform index funds. Yet, many investors continue to ignore this truth. Outside of a small group of exceptional investors, active management is a waste of time and money.
The Power of the Crowd
Why does the delusion of active management persist? One theory is that there is a general lack of understanding as to why active strategies are doomed to fail in most cases. One important reason, as illustrated by the “wisdom of crowds” concept, is that creating accurate estimates becomes more difficult as the number of estimates increases. The average of numerous estimates tends to cancel out extreme values and come closer to the actual number.
This concept was demonstrated in a contest at Riverdale High School in Portland, Oregon, where students had to guess the number of jellybeans in a jar. The average guess was close to the actual number, but only a few students outperformed the average. This suggests that the majority of participants are likely to underperform the market.
The Origins of the Active Management Delusion
Prior to the Securities Acts in the 1930s, speculators relied on insider trading and market manipulation due to the difficulty of outperforming the market. These acts improved market integrity but also gave rise to the delusion of active management. As companies were forced to disclose financial information, the market became temporarily inefficient, providing competitive advantages to those who could interpret the data. However, as more investment professionals emulated these methods, the market became more efficient and outperformance became increasingly rare. Benjamin Graham, one of the pioneers of value investing, warned that beating the market was too difficult for most, but his warning was largely ignored.
Moving Beyond the Fear of Obsolescence
The belief that one can consistently beat the market continues to persist, even in institutional consulting. Many firms base their value proposition on their ability to select managers and allocate assets. However, these strategies are subject to the wisdom of crowds and are unlikely to outperform average estimates or index funds. To improve client outcomes, investment consultants and advisers must accept this reality and focus on adding value in other areas, such as defining investment objectives and optimizing capital deployment.
Advisers and consultants must recognize and respect the wisdom of crowds. By doing so, they can better serve their clients and add extraordinary value. Letting go of the obsession with outperformance allows for a more holistic approach to financial management.
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All posts are the opinion of the author. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute or the author’s employer.
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