Who Should Try to Beat the Market?

Benjamin Graham is the father of value investing. He literally wrote the book on how to analyze a company's value and pick superior investments. Warren Buffett once said that "I really learned all I needed to know about investing" from Graham's book, The Intelligent Investor.

But as I wrote last week, Graham gave an interview shortly before his death in 1976 that calls his own ideas into question. Asked whether he advised selecting individual stocks to beat the market, Graham replied:

In general, no. I am no longer an advocate of elaborate techniques of security analysis in order to find superior value opportunities. This was a rewarding activity, say, 40 years ago, when our textbook "Graham and Dodd" was first published; but the situation has changed a great deal since then. In the old days any well-trained security analyst could do a good professional job of selecting undervalued issues through detailed studies; but in the light of the enormous amount of research now being carried on, I doubt whether in most cases such extensive efforts will generate sufficiently superior selections to justify their cost. 

This took me aback. There is exponentially more research being conducted today than there was in 1976. If Graham was skeptical about buying individual stocks then, what would he be doing today?

I had lunch with Wall Street Journal columnist Jason Zweig this week. Zweig wrote commentary and footnotes in the latest edition of The Intelligent Investor and is more familiar with Graham's thinking than almost anyone.

"Would Graham have all of his money in Vanguard index funds if he were alive today?" I asked.

"No, I don't think so," Zweig said.

Instead, Zweig thinks Graham would have advised those who have an edge at stock-picking to do so, while recommending those who don't take a passive approach with index funds. "He would advise knowing your advantages and your disadvantages, and not playing a game you have no advantages in." Zweig said.

This seems obvious, but too many investors fail to honestly ask themselves whether they have an advantage, and if so, what it is.

Fewer investors have an advantage than think they do. The reason is simple: Luck skews our perception of how skilled we are.

I have no medical experience. If you put me in an operating room and told me to perform open-heart surgery, the odds that I could do so successfully are exactly zero percent. Same with building a skyscraper or sequencing a genome. Those without skill in these fields will fail 100% of the time, so most don't bother trying.

Investing is different. Give a monkey $1,000 and a brokerage account, and the odds are decent -- about 50/50 -- that he will make money in the short run. He may even beat brilliant professionals. In his book The Success Equation, Michael Mauboussin writes that the best way to determine whether an activity involves skill or luck is to ask if you can lose on purpose. In short-term investing, you probably can't. There are short-only hedge funds whose goal is to pick losing stocks. Most can't do it consistently. Few other fields are like this.

Short-term luck deludes hordes of investors into thinking they can beat the market when they stand little chance of doing so. Over the long run, luck erodes, and true investment advantages shine through. And the results are clear: Most investors do not have an advantage. The majority of those who try to beat the market end up underperforming it.

This got me thinking: What is my advantage as an investor trying to beat the market?

I think it's simply time. I'm patient to the point of obsessive when it comes to delayed gratification. I bought stocks all the way down in 2008 and 2009, dreaming about what they'd be worth in 2038 and 2039. That's a big advantage over Wall Street, whose definition of "long term" is the time between Lightning Round segments on CNBC. If Wall Street is thinking about the next ten months, and you're thinking about the next ten years, case closed -- that's your advantage. Last year, I asked Rob Arnott, a pioneer of index investing, if anyone should pick stocks. To my surprise, he wasn't against the practice. "It's also not necessarily all that hard because Wall Street is now so obsessed with short-termism that long-term value doesn't matter to the decisions of vast throngs of institutional investors," he said.

Time can be the only advantage necessary for an investor focusing on index funds or wide diversification. If you're picking a smaller number of individual stocks, you need an advantage there, too.

Entire books can (and have) been written on how to gain an advantage picking individual stocks. It's not a topic for one article. But if there's a common denominator of successful strategies, it's thinking about investing in businesses, not stocks, and believing strongly in the concept of reversion to the mean.

My colleague Ron Gross says we should think of the market as a company market, not a stock market. Doing so can change your thinking 180 degrees. Most people understand that businesses will have a bad quarter or a rocky year once in a while. It's a normal part of being a business. But those same people tend to react to a bad quarter in the stock market as a harbinger of doom that should be avoided at all costs. That causes all kinds of bad behavior. Shifting your thinking ever so slightly to asking the question, "Is this a good business?" instead of "Is this a good stock?" alone can be an investing edge, since so few investors do it. It focuses your attention on having an ownership stake in a business's future profits, which you can do, from trying predict the madness of the stock market, which you can't.

A religious faith in the concept of reversion to the mean can also be an advantage. As investor Dean Williams put it, reversion to the mean is the simple idea "that something usually happens to keep both good news and bad news from going on forever." After booms come busts, and after busts come booms. Above-average valuations are followed by below-average results. This story repeats itself again and again throughout history. It's simple stuff, but it's one of the most powerful forces in finance because, by definition, only a small portion of investors can be contrarians. It's much easier to say "I'll be greedy when others are fearful" than to actually do it. But those who can truly can train themselves to be skeptical of outperformance and attracted to underperformance will likely do better than most. They have an advantage.

What matters is that you know what your investing advantage is. Can you articulate your advantage? Are you being honest with yourself when assessing it? If not, think twice about trying to the beat the market. Passive index funds can be a great alternative. I think Ben Graham would agree.

Check back every Tuesday and Friday for Morgan Housel's columns on finance and economics. 

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  • Report this Comment On August 02, 2013, at 10:54 AM, HectorLemans wrote:

    "If Wall Street is thinking about the next ten months, and you're thinking about the next ten years, case closed -- that's your advantage."

    It really is that easy...and hard. I've been investing about 15 years now and have always outperformed the market in any 2 year or more period with one important exception: My "play" money that I use to just speculate - usually to buy options, short companies, etc. - has had abysmal returns. It aggravates me to no end. I'm running my 401k, Roth IRA and an IRA for my parents that has spectacular returns (even during the financial crisis!) and yet I can't even get the timing right on a few call options. The difference? I always buy long term for the IRA's. A dip in the market just means stocks are at a discount. For my play money, a dip in the market means my thesis was wrong and I've got to exit my position ASAP; usually at a loss.

  • Report this Comment On August 02, 2013, at 12:01 PM, kyleleeh wrote:

    Although I did well picking individual stocks, I made the switch to Vanguard ETFs in 2011 for one reason...transaction fees. Want to invest a piece of your paycheck? 10 bucks. Want to reinvest that dividend check? 10 bucks. Want to move money from one investment to another investment? 10 bucks to sell the first one and another 10 to reinvest the money. In the end I realized I was better off with a no transaction ETF with a low expense ratio.

  • Report this Comment On August 02, 2013, at 1:01 PM, Mathman6577 wrote:

    The best strategy is to do both index funds and individual stocks (mainly for their dividends)

  • Report this Comment On August 02, 2013, at 1:33 PM, daveandrae wrote:

    After 15 loooooong years in this business I have learned that the beginning of wisdom lies not in outperforming the "market." The beginning of wisdom comes when you realize that you are "outperforming" most investors, which, by definition, must include everyone you know or will ever know.

  • Report this Comment On August 02, 2013, at 10:21 PM, MartyTheCanuck wrote:

    Advantages :

    Time - you explained it better than I could

    Being your own adviser - you can't fire yourself for a down quarter or year

    Knowing why you own a stock - the reasons remain true even if the stock goes lower

    Finding stocks that suit your style and risk tolerance

    Too many investors have very little knowledge of how to read financial reports and rely on tips from brokers, financial media, or their brother-in-law. Knowledge is a powerful advantage.

  • Report this Comment On August 03, 2013, at 9:21 AM, Rake80 wrote:

    "Zweig wrote commentary and footnotes in the latest edition of The Intelligent Investor...."

    With due respect to Zweig's journalism, his commentary and footnotes spoiled the pleasure of reading Graham's work alone. They were pathetic to say the least. Please pick up an old copy of Intelligent investor( without any Zweig and with original footnotes) to appreciate the wisdom of that book.

    The second part of your statement made me cringe really.

    "...and is more familiar with Graham's thinking than almost anyone."

    Is Zweig the CEO of Berkshire? Is he one of the many great Value investors? Could he get a job at Tweedy Browne??

    Maybe I am being too harsh. But I appreciate your writings and look forward to them and don't expect you to write such statements which are prima facia wrong!

    Cheers,

  • Report this Comment On August 03, 2013, at 9:25 AM, Rake80 wrote:

    Agree to the main thesis in the article though. Finished reading Intelligent Investor( without Zweig of course) last month and I can confirm that this is exactly the message from Graham. Intelligent Investor is worth reading again and again.

  • Report this Comment On August 03, 2013, at 9:28 AM, TMFHousel wrote:

    <<Maybe I am being too harsh. >>

    Yes.

  • Report this Comment On August 03, 2013, at 7:32 PM, maurice80 wrote:

    What about DAVID and TOM's followers?

  • Report this Comment On August 03, 2013, at 7:52 PM, colleran wrote:

    Malcolm Gladwell, in his book 'Outliers', notes that one thing the Silicon Valley billionaires (Gates, Jobs, Dell, etc.) have in common is the year they were born, all in the early 50s. I don't want to take anything away from them, but I have come to the conclusion that luck has much more to do with financial success in life than ability.

    I started investing in late 1999 and in invested in tech companies. Many of them are no longer in business. I have recovered since then but I have not beat the market overall. I suggest that those who do are either Warren Buffett or lucky.

  • Report this Comment On August 03, 2013, at 8:09 PM, AnsgarJohn wrote:

    Graham said use stock screens, not index funds.

  • Report this Comment On August 03, 2013, at 9:14 PM, TMFHousel wrote:

    <<What about DAVID and TOM's followers?>>

    I didn't say it explicitly in the article, but the advantages I point out -- buying companies instead of stocks and taking a long-term approach -- are the backbone of Motley Fool investing philosophies. That's always been the advantage the Fool has recommended investors seek over the market.

  • Report this Comment On August 03, 2013, at 10:07 PM, Mega wrote:

    It's kind of funny how much more attention some people give to these 100 words than his other 500,000+ words.

  • Report this Comment On August 04, 2013, at 1:16 AM, tcgcompliance wrote:

    My theory, which has paid off for me, is to invest in companies whose business I can understand, American Express, Mastercard, Ford, Pcar, Whole Foods are examples and I use their products, I am not a bioengineer and I don't understand what their companies do, when I have strayed I have lost!

  • Report this Comment On August 04, 2013, at 1:17 AM, tcgcompliance wrote:

    I have equally stuffed myself with technology I don't understand!

  • Report this Comment On August 04, 2013, at 3:41 AM, GregTrocchia wrote:

    Colleran-

    If Gladwell's observations about Silicon Valley Billionaires were true when he wrote his book, I submit that they don't hold any longer. Zuckerberg, Musk, Page, and Brin (for example) don't fit that picture.

    In fact, as a space travel enthusiast, I can provide an alternative rationale for Gladwell's observation. The generation born in the early '50s was treated to growing up with the Mercury, Gemini, and Apollo programs and the excitement about science, technology, and the future that these programs inspired. If you were of that age and had anything like a technical bent, it was difficult to avoid being drawn into the world of high tech and, by extension, would be more likely to end up in Silicon Valley. Chance does play a role, but as they say "fortune favors the prepared mind".

  • Report this Comment On August 04, 2013, at 4:53 PM, damilkman wrote:

    Greetings. I absolutely agree with this article. I had about half my play money in QQQQ. I rode it until I was pretty sure it was peaked and called it. QQQQ dropped and I clucked at how good I was. I put my cash in researched companies and they all went WOOF WOOF WOOF!!! Meanwhile QQQQ recovered and has gone beyond the highs that I sold at. Oops!!

  • Report this Comment On August 04, 2013, at 10:51 PM, HistoricalPEGuy wrote:

    Morgan,

    Great article - your points are really dead on. Last month I wrote a blog shocking similar to this piece... (http://caps.fool.com/Blogs/fear-greed-and-the-new/848663).

    Successful individual investing means finding a niche - a way you approach the market or an industry understanding that is unique to you.

    If you watch CNBC regularly or read WSJ everyday to help you make stock picks, you probably won't do better than a coin flip, but you might in the short term.

    Thanks for making that point clear, Morgan. I would add that CAPS is a great way to build confidence and find your "investing advantage" without risking a single dime.

    -- HPEGuy

  • Report this Comment On August 05, 2013, at 9:25 AM, nastrading wrote:

    Index funds are not the panacea they are made out to be.

    Most index fund investors substantially under-perform the index fund headline (time weighted) returns do to the timing of additions and withdraws of funds (money weighted returns).

    With a few precautionary steps (Diversification of investment choices, avoiding speculative issues, longer term holding period) there is little harm to choosing ones own stocks.

    The more the masses think index fund investing is the way to go, the more opportunity there will be in picking high quality companies that are not included in an index and consequently don't have that huge pool of buyers inflating prices.

    If you invest with a 5+ year time horizon the advantage grows even larger, in my opinion - Almost zero transaction costs, almost no taxes, and no mgt fees of any kind.

  • Report this Comment On August 05, 2013, at 11:48 AM, TMFDukenewkirk wrote:

    Great article Morgan. The 'only' advantages I have are the ones you pointed out. Personally, I'm currently up 3.8% annualized over 8.5 years vs the S&P. During the last massive pullback, I was even briefly below par.

    Patience, faith in others' understanding on our Motley Fool boards (the right people, of course) of businesses beyond my grasp or in my own judgement as well as the overall 'truly long term' direction of our market are quite literally 'all' I have going for me and that's proven more than enough to trounce the market.

    Also, discriminate allocations are vital in my case. I've been wrong far more often than right as my Fool scorecard indicates, however, while wrong so often, I've always made those speculative picks much smaller and haven't been afraid to book small losses and move on, while initially more speculative investments that have proven themselves and grown into big winners, I've allowed to keep growing, eventually leading to a very productive list of businesses in my portfolio. Again here, patience in finding and refining this collection required years, not months of enjoyable effort for me personally. Tempered fear and joy are a constant effort in this process as well.

    Rob

  • Report this Comment On August 05, 2013, at 12:16 PM, SkepikI wrote:

    Though I occasionally break discipline and speculate on risky or seemingly crazy new ideas because they interest me I am nearly always regretful. On average these "undisciplined brain shorts" do worse than my index funds. Good solid companies that are well run and well led, mostly do BETTER over time if I buy at disciplined "beat downs" or "unfashionable judgements". I could care less if they are out of fashion and declining in price if they are earning good returns, paying out 3% or even 5% dividends based on my buy price. In fact I WANT them to be beat down occasionally so I can buy more, and BDM usually helps me out here. The trouble is after a bit, as your portfolio escalates and expands, you either have to pay A LOT more attention or take bigger risks from random events changing your good pick. Like the driving force and founder dying somewhat unexpectedly (APPL) or getting in the Fed's crosshairs and losing a major lawsuit. There are just so many of these things you can follow and absorb without losing your major purposes in life, which for me IS NOT OBSESSING ABOUT MY PORTFOLIO.

    So at a certain point, if you want to stay an amateur investor and a professional worker or retired person, you need to use indexes intelligently and dabble with a few individual picks. JOMO

  • Report this Comment On August 05, 2013, at 2:24 PM, hbofbyu wrote:

    So in other words, if we didn't have complicated tax laws a financial adviser would be worthless.

  • Report this Comment On August 05, 2013, at 2:38 PM, earlyseller wrote:

    I am an aggressive conservative. That means I write Puts on quality companies I would be pleased to own like: IMAX, INTC, DIS, WFC, MDRX, WETF, AMZN mini, QLIK, VPHM, INFN, SD, ARNA and I have written covered Calls on stocks of companies that I am OK to sell or just take additional "tax-deferred" income in my IRAs and ROTH IRAs.

    An 85 year old friend of mine some 30 years ago would put BUY orders in for stocks at 15% to 25% below the then current market price only if he liked the company. He said, "If it gets filled, he saved 15% to 25% on the purchase and if not there would be another trolley to come along in another 15 minutes." His system was simple: wait for a bargain price and buy only what was good and if you did not buy it, buy something else just as likely to be good. It took me 20+ years to learn how right he was and how the market has changed to let me do it similarly with long term holds and short term Puts.

  • Report this Comment On August 06, 2013, at 2:00 AM, TMFDukenewkirk wrote:

    Good points Skepikl. I failed to mention, currently still, around 50% of my portfolio is of the stalwart variety business type you adhere to. I merely commented on my fun 50% that are still substantially more than speculation unless of course one's not inclined at all to look out a few years and envision or acknowledge a strong business trend in innovators like LinkedIn, Netflix or the future of 3D printing to mention a few examples.

    Investing success can take many forms, and as long as the key points Morgan's espoused in this article are the foundation of whichever investing style employed, chances for success are greatly increased.

    For some of us, however, investing is a joy, a form of continuous entertainment as well as wealth creation and therefore 'obsessing' is no different than watching sports, TV, movies, rock climbing or whatever. My morning reading begins with a stroll over the Motley Fool boards and ends with a glimpse at the standings...of the stocks in my portfolio, my Caps and Space Camp scorecards. It's not work at all.

  • Report this Comment On August 06, 2013, at 2:31 AM, TMFDukenewkirk wrote:

    >>>Though I occasionally break discipline and speculate on risky or seemingly crazy new ideas because they interest me I am nearly always regretful<<<

    First off, quite right Skepikl. I failed to mention above that half my portfolio are businesses of the type you've espoused investing in. Those do allow me to sleep better. But they don't entertain or excite.

    >>>There are just so many of these things you can follow and absorb without losing your major purposes in life, which for me IS NOT OBSESSING ABOUT MY PORTFOLIO.<<<

    Bear in mind, there are those of us who greatly enjoy 'obsessing' about investing, however. Instead of reading morning sports, which during a season I'll devote 10 minutes to morning to morning, or reading/watching pointless and ironically named NEWS (cause really it's usually nothings new(s)), I prefer to start my mornings reading the Fool boards, checking out the 'standings' of my portfolio's scorecard, my Caps or Space Camp (at Supernova) cards, instead. Frankly it's time very well spent if you genuinely enjoy it. And really, why should I logically care more about my hockey team's standings? Yet most folks devote more to their teams than their futures.

    Hunting down innovative businesses that many would simply label as 'speculation' is forgoing a very entertaining aspect of investing. Finding businesses in early stages that are shaping our world can be very lucrative if done with reasonable caution as per my earlier comment. A BRK-B 2 years ago was a no brainer, sleep easy pick that warranted a sizeable allocation off the hop. That a LNKD, BOFI, Z would double for me in a year was never unthinkable. That their once 2% allocations are suddenly 4% is both a fun and profitable experience. That little has changed except further positive developments in all of those businesses is a reason that I allow them to hold those allocations 'patiently' even though they do perhaps still represent greater risk. Most of all, finding a few wonderful picks like these and having the odd ones go ten-bagger leaves me worrying little about my many small failures with that half of the portfolio as they are more than covered and regrets remain an unproductive exercise I don't participate in.

    In fact, regret is one of the great antagonists of the Morgan Housel story above as it breads doubt, which leads to inconsistency in methodology and fear running amok.

    So as you pointed out, folks have to find their own comfort zone by first determining who they are and what they have time for and then most importantly of all, they have to believe in what they are doing (hopefully that's working), and exercise great patience.

  • Report this Comment On August 06, 2013, at 10:42 AM, SkepikI wrote:

    ^ Indeed. Moderation in all things is the secret to.....Mediocrity.

    Some time spent in this world is certainly amusing and interesting. Which is why I still bother to do it. There are many times however when I just dont feel like it or am flat out unable...like the week I spent floating the middle fork of the Salmon River in ID or the two weeks in Tuscany last June. If that risks my portfolio, or major losses, which might cripple my ability to go visit Tuscany or float the Salmon, then sorry, I'm out.

    At some point, everyone discovers they likely have more money than time, sooner if they have been diligent and paying attention young.

  • Report this Comment On August 06, 2013, at 10:48 AM, SkepikI wrote:

    ^ and if you think about it too late, you discover certain things do not work as well as they used to...knees, hips, shoulders and you no longer have time to do those things you always planned to because while they were never risky then, they are now, or they are just not fun anymore..ouch...ack ..dang..ooff.

  • Report this Comment On August 06, 2013, at 5:55 PM, Flogiston wrote:

     

    I totally agree with the gist of this column, except for one thing: reversion to the mean.

    Reversion to the mean sounds too much like technical analysis. Okay, it's a kind of long-term TA whereas the "traditional" TA is only short term, but it's TA nonetheless.

    Apart from being TA, reversion to the mean also focuses on a stock (or rather, on the stock's price), not on the company. This contradicts the gist of the article.

    Reversion to the mean may not occur for a decade or even longer. Just take the most successful stocks (sorry, companies) of the SA and RB newsletters as examples: stellar returns, and why? Because reversion to the mean did <i>not</i> occur.

    Still, the article is a great read, and Morgan mentions some very true and noteworthy points, for which I thank him. I just thought I needed to comment on the reversion to the mean theory.

    Flo

     

  • Report this Comment On August 06, 2013, at 5:55 PM, StockGamingCom wrote:

    I bought small caps in April of 2009. I got whip-sawed out many times because I couldn't handle the volatility. If I strapped myself in, my portfolio would be up 1000%.

  • Report this Comment On August 06, 2013, at 6:27 PM, BookValueEd wrote:

    Thanks for the thoughtful post. Certainly most active investors suffer from the Lake Wobegon Effect--we're all above average. Sadly, evidence doesn't quite support this belief. For those courageous enough to admit our limitations, it might make sense to reframe the idea of success: it could be that skilled investing is not about winning more than everyone else, it's really about losing less. Indexing does provide the edge when viewed this way. And in an era where most professional money managers fail to beat the averages, this might be a handy perspective to keep in mind.

    Now, back to picking stocks :-)

  • Report this Comment On August 07, 2013, at 6:06 AM, AnsgarJohn wrote:

    @TMFHousel did you read the whole 1976 Graham interview? The quote is very much out of context.

  • Report this Comment On August 07, 2013, at 8:08 PM, lngtrmcptlgns wrote:

    Another article about "beating the market" that ignores the fact that most investors have no clue how to even track their own performance.

    And the Motley Fool writers apparently have no interest in showing them.

  • Report this Comment On August 07, 2013, at 8:52 PM, knighttof3 wrote:

    "Last year, I asked Rob Arnott, a pioneer of index investing, if anyone should pick stocks. To my surprise, he wasn't against the practice."

    Why would he be? His RAFI indexes are based on stock-picking, unlike the traditional free-float-adjusted-market-cap-weighted index funds and ETFs. Why are you surprised?

  • Report this Comment On August 07, 2013, at 11:46 PM, simplextester wrote:

    testing please ignore

  • Report this Comment On August 07, 2013, at 11:54 PM, simplextester wrote:

    testing please ignore

  • Report this Comment On August 08, 2013, at 12:27 AM, sliderw wrote:
  • Report this Comment On August 08, 2013, at 12:27 AM, sliderw wrote:
  • Report this Comment On August 08, 2013, at 2:14 AM, brandstudere wrote:

    My advantage - outsourcing, plain and simple. Purchase a membership to the Stock Advisor and follow their advise. I own 19 stocks (businesses) with 10 of them having had double digits growth and only two in the red. Thank you David and Tom! Oh, and my wife loves it!

  • Report this Comment On August 14, 2013, at 7:32 AM, Peak2Trough wrote:

    "Another article about "beating the market" that ignores the fact that most investors have no clue how to even track their own performance.

    And the Motley Fool writers apparently have no interest in showing them."

    ---

    I couldn't agree more. Can someone point me to a Fool article that says they can help you beat the market on a risk-adjusted basis? I do not believe I have seen one.

    It's actually pretty easy to beat the market. In fact it requires only two things:

    1. Load up on risk

    2. Be lucky

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