Challenges of Outperforming the Market

Key Insight

Achieving investment results superior to broad market averages like the DJIA or S&P 500 is extremely difficult, despite the belief that moderate skill should yield better outcomes. Historical evidence from numerous large investment funds, which employ top financial analysts and robust research departments, shows they consistently fail to outperform the market. Studies covering periods like 1960 to 1968 indicate that random portfolios of New York Stock Exchange stocks often performed better than mutual funds in the same risk class, with differences of 3.7% and 2.5% per annum for low and medium risk portfolios, respectively.

Two primary explanations account for this difficulty. First, the stock market's current prices may already reflect all known facts about a company's past, present, and reasonably foreseeable future, making subsequent price movements essentially random and unpredictable. The proliferation of security analysts, numbering in the hundreds or thousands for important common stocks, contributes to this by ensuring current prices broadly reflect a consensus of informed opinion, making it challenging for any single analyst to gain a consistent edge.

Second, many security analysts may have a flawed basic approach to stock selection. They often prioritize industries and companies with strong growth prospects and excellent management, implying a willingness to buy at any price, while avoiding less promising companies regardless of low prices. This strategy is problematic because few companies sustain high, uninterrupted growth indefinitely, and most experience cycles of ups and downs. The market's inability to be consistently beaten suggests that identifying superior individual selections is a difficult, potentially impracticable assignment, even for highly intelligent and knowledgeable investors.