Don't Put Beating the Market Atop Your To-Do List

Jeremy Glaser: For Morningstar, I'm Jeremy Glaser. Does it matter that it's difficult to beat the market? I'm here today with Alex Bryan, he is the director of passive strategies research for North America, he is also the editor of Morningstar's ETFInvestor newsletter, to find out.

Alex, thanks for joining me.

Alex Bryan: Thank you for having me.

Glaser: Alex, you recently took over as the editor of ETFInvestor, and in your first cover story one of the things you talked about was that you think it's difficult to beat the market. Why is this the case?

Bryan: I think there is a lot of competition from well-informed investors that makes it very difficult to consistently beat the market. While some investors may be better informed than others, it's really difficult to maintain an informational edge in a world where it's illegal for managers to selectively disclose information to some investors, not to others. Anyone who has the proper motivation, resources, and training can access the same information. They are all looking for undervalued opportunities, stocks or bonds that offer higher returns relative to the risk. 

So, if they come across one of those stocks or bonds, there's a lot of competition, a lot of money will flood into those undervalued securities to the point where the prices get bid up to where the future returns are commensurate with the risks that those securities offer. So, really, competition is the key here. It's what drives prices to be close to fundamental value.

Glaser: Are you saying here that the market's efficient and that there's no opportunity for outperformance?

Bryan: Not quite. While it's difficult to beat the market, it's not an impossible task. The markets aren't efficient because people aren't perfect. We are all susceptible to fear and greed and that can cause us to do some dumb things with our money. Like selling out of an investment after the market crashes and returns are actually probably going to be higher going forward. Or maybe losing our valuation discipline after we've had eight- or nine-year bull market and things feel safe. 

A lot of investors aren't perfectly rational. We are susceptible to these emotions. We might extrapolate past returns too far into the future, underreact to new information or roll dice on risky stocks and in hopes of making it big. There's lots of inefficiencies in the market, but that doesn't necessarily mean it's easy to beat the market, but it's not perfect by any stretch.

Glaser: If you are trying to maybe exploit some of these inefficiencies, you think it's better to do so using a model than to have kind of an active stock-picker, an active bond-picker. Why is that?

Bryan: I think there's multiple ways to be successful, but I tend to prefer models because models are more consistent, and they are less susceptible to cognitive biases than qualitative judgment might be. Qualitative judgment, while there are certainly great stocker-pickers out there who use qualitative judgement to great effect, it really relies on intuition, and intuition is a very hard thing to develop in an unpredictable environment where there is a lot of noise, there is a lot of unpredictability. That means it's difficult to get good-quality feedback. It's hard to know if your judgment actually was skillful and resulted in you making money or if it was just the result of luck, if you just happened to be in the right place at the right time. 

I think models are good because they are better at picking out moderately predictive relationships in this noisy data and applying those insights consistently, which allows investors to profit from the relationships that are in fact there. But I do think you can be successful either way. I just tend to prefer models because I think they are more consistent and less susceptible to biases.

Glaser: Then maybe pulling back a little bit, does any of this really matter? I mean, does beating the market, is that in and of itself, something you should be trying to do? Is there anything wrong with just accepting market returns?

Bryan: Beating the market, while it's great if you can do it, it's not a requisite for investment success. Now, that being said, if you can beat the market, a small advantage when it's compounded over a long period of time can add up to a lot of money. It's actually pretty far down the list of things that you should be worried about. 

The market over the long term works for investors. The most important drivers of long-term returns are interest rates and the compensation that investors require for holding risky assets. Sometimes, things will turn out better than expected, and risky assets will just shoot the lights out. Other times, risky assets will offer disappointing returns. But I think over the long term, positive and negative surprises tend to wash out and you are left with a competitive risk premium for your efforts for taking on that risk. 

I think just owning the market will actually probably let you do better than most investors that are getting a bit greedy and trying to beat the market. Because you start out with a huge head start with the lower fees that index funds offer. I think being broadly diversified, keeping your costs low, those are the most important things and staying in the market through thick and thin even when things are scary, that's what I think is more important than trying to beat the market.

Glaser: Alex, thank you.

Bryan: Thanks for having me.

Glaser: For Morningstar, I'm Jeremy Glaser. Thanks for watching.