There have been numerous studies that suggest it is impossible to beat the market as an individual investor. Beating the market is described as so difficult, only the best and the brightest minds on Wall Street achieve it.
So, if that's the case, who are individual investors to think they can pull off the miraculous feat of outperforming the larger market? Ludicrous, right?
Perhaps. But before you write off investing in individual stocks, there are a few flaws in that argument you should consider that Wall Street doesn't want you to know.
Image source: Getty Images.
Professional incentives
Using professionals as a benchmark for individuals is problematic because institutions have unique incentives that drive their trading behavior. The two main motivators are investor retention and performance-based bonuses.
In other words, fund managers need to generate high returns every year because if they don't, they will likely lose investors and make significantly less money from their year-end bonus.
These are powerful motivators to pursue short-term gains. Meanwhile, individual investors have no pressure to produce immediate results.
High turnover among funds
Ironically, the conclusion investors should arrive at after hearing that over 90% of fund managers underperform the market is that chasing short-term gains is disastrous for long-term performance.
The main reason for this is high turnover. Turnover is the change in positions within a portfolio. At The Motley Fool, we advocate for low turnover, so your companies can compound on themselves over the long run.
In 2019, Morningstar found the average domestic stock fund had a turnover rate of 63%. Put another way, from the beginning of the year to the end, the average fund's holdings were 63% different.
Consequences of high turnover
As fund managers chase near-term results, there are very real long-term consequences for their performance. The two main costs are a lack of compound interest and higher taxes due to short-term capital gains.
Compound earnings is the byproduct of great investing, and it should be the goal of every individual investor. Compounding occurs when you start earning interest on your interest. If you earn a 10% return on a $1,000 investment, you'll earn more dollars each year as the overall portfolio increases. Compounding is hard to notice in the early years, but the results are dramatic after a few decades.
Very few fund managers ever get to enjoy this benefit because of the constant pressure to chase hot stocks. Therein lies a very real advantage for you as a retail investor: you're accountable to no one but yourself, and you face no outside pressure to chase hot stocks for near-term results.
Additionally, high turnover results in short-term capital gains taxes. These are the highest taxes you can pay on the sale of stocks. Unfortunately for fund managers, as they chase short-term results, they are frequently forced to sell stocks , resulting in higher taxes. These taxes eat into the fund's real returns, which is yet another advantage for long-term investors.
Media pressure to invest like the pros
The more you unpack these studies about professional funds' returns, the more you realize just how beneficial it is to simply hold on to your winning stocks. And yet, the financial media bait investors into thinking that's the game they need to play.
Take the slogan from Jim Cramer's wildly popular show Mad Money for example: "There is always a bull market somewhere, and I will try to find it for you."
This suggests that individual investors should chase returns wherever they might be in the market. Not only is that an exhausting exercise, it also removes the one advantage you have over the institutions, which is time in the market.
Instead of trying to trade around those market shifts, investors should use them as an opportunity to buy high-quality companies at cheap prices.
Wall Street is usually wrong about big winners
Evidence of professional underperformance can also be seen in the numerous mega winners that were written off by Wall Street as doomed to fail.
Amazon (AMZN -1.82%) is the most prolific of these examples. From headlines like "Amazon.bomb" to the countless pundits predicting the company's failure, Wall Street's rejection of this huge winner is well documented.
Yet, Amazon's total return compared to the S&P 500 speaks for itself:
AMZN Total Return Level data by YCharts
More recently, Wall Street has focused its criticism on electric vehicle maker Tesla (TSLA 4.07%). Doubts about the company's ability to maintain its wide lead in the industry as well as negative sentiment toward its various other disruptive technologies have dominated headlines and talk show discussions.
Meanwhile, the stock has outperformed the market massively over the last decade:
SPY Total Return Level data by YCharts
This isn't a comment on Tesla's business but rather further evidence that Wall Street has a track record of missing huge winners.
Outperformance lies in patience
When you extrapolate why institutional investors underperform, what you learn is that overtrading is terrible for long-term performance.
Instead of throwing in the towel because the pros can't beat the market, you should conclude that you have a massive advantage by not having clients and year-end bonuses to impact your portfolio decisions.
And finally, whether it's the short-term nature of Wall Street's investing outlook or a general lack of optimism for new and disruptive companies, the financial media's track record of missed winners should only add to your conviction in your ability to...beat the market.
