Should you try to beat the equity market?
There are many aspects of personal finance and investment that apply to all of us. For example, with a bit of application we can all find a sensible trade-off between spending today versus saving for the future; we can all determine an asset mix with a reasonable balance of risk and return; and we can all go about our investing in a tax-effective way to maximise the long-term benefits.
What we can’t all do, however, is beat the market. Just not possible. Maths is the culprit.
A lot has been written on the topic. Proponents of active investment (ie. trying to beat the market) point to examples of excellent returns that have been delivered by select talented investors, as well as the fact that there are numerous poor quality businesses in the index. Proponents of passive investing (ie. trying not to beat the market) point to the lower costs offered by index funds, and the often uninspiring results delivered by the funds management industry as whole.
Neither side has a mortgage on the truth. The right way for an investor to think about the choice between active and passive investment depends very much on who they are. Let me elaborate.
Firstly, there is no escaping the market math. The average return received by all the investors in a market must be equal to the average return delivered by that market. It follows that if you had to give one piece of advice to all participants in the market, it could only be this: find a low cost way to invest in the market index. Averages being what they are, any time, effort or cost incurred by the overall market in pursuit of a better than average result can only be for naught (on average).
At the same time, it is possible to beat the market. The problem is that only the best active investors can expect to do so, and in a market full of smart, hard-working people, that is a tough ask. You can think of it a sporting contest where there is a cost to enter, and only the winners share in the prizes. If you are a middle-of-the-pack competitor, it probably doesn’t make financial sense for you to enter.
To justify active investment management, you need to be noticeably better at it than the middle-of-the-pack competitor. If you have a good measure of insight, dedication and the ability to act dispassionately, it may well make sense for you to try to beat the market by doing your own stock selection. Alternatively, if you have the ability to spot a manager with these qualities, it may make sense to pay them to do the leg work for you.
Mediocre active investment however, is worse than a zero-sum game. If you don’t fall into one of the above categories, it is probably in your best interests to allocate your equity dollars to low-cost equity index products, and save yourself some trouble and/or fees.
Commentators on both sides of the fence may claim to be able to answer the active versus passive question, but ultimately, this is one for you.
Tim Kelley is Montgomery’s Head of Research and the Portfolio Manager of The Montgomery Fund. To invest with Montgomery domestically and globally, find out more.
Tim joined Montgomery in July 2012 and is a senior member of the investment team. Prior to this, Tim was an Executive Director in the corporate advisory division of Gresham Partners, where he worked for 17 years. Tim focuses on quant investing and market-neutral strategies.
This post was contributed by a representative of Montgomery Investment Management Pty Limited (AFSL No. 354564). The principal purpose of this post is to provide factual information and not provide financial product advice. Additionally, the information provided is not intended to provide any recommendation or opinion about any financial product. Any commentary and statements of opinion however may contain general advice only that is prepared without taking into account your personal objectives, financial circumstances or needs. Because of this, before acting on any of the information provided, you should always consider its appropriateness in light of your personal objectives, financial circumstances and needs and should consider seeking independent advice from a financial advisor if necessary before making any decisions. This post specifically excludes personal advice.
david klumpp
:
Thank you again Tim for another excellent and thought-provoking article. Though I like to think I have some of the right qualities needed to successfully select and manage a portfolio of stocks “insight, dedication and the ability to act dispassionately”, it is not an easy task. Thus I have been gladly, and gradually increasing the proportion of my investments that are in various Montgomery funds, both Australian and Global.
Tim Kelley
:
Thanks, David. May we continue to justify your confidence in us.