How hard (or easy) is it to outperform?

It’s not supposed to be easy. Anyone who finds it easy is stupid.
Charlie Munger

I started writing a post about how the recent market volatility provides a good moment to reflect on your skills as an investor, but I realized that the more interesting topic – that is somewhat related – is how easy or hard it is to outperform the market. I think this is really the most important question that every investor faces since the answer has huge implications on what kind of strategy you should follow. While this is a very fundamental question I don’t think there has ever been a good definitive answer. Are markets almost perfectly efficient and is your best bet an index fund? Do you need 150+ IQ points and read 500 pages/day to have a shot at out performance? Can you have an edge with an average or below average intelligence, but with a contrarian mindset and enough time? Can you be successful if you are really smart, but when you lack the “magic” psychological profile?

What kind of people should consider what kind of strategy?

Usually, this is a question that isn’t even asked when people ask for investment advice. Ask for investment advice on boggleheads.org and everybody is going to advise a portfolio of low-cost index funds. Ask the question somewhere else and they probably recommend their own strategy; which could be buying owner operators, compounders, cheap value stocks, magic formula stocks, swing trading, forex trading, and whatever else exists.

Some of these strategies are probably not a good idea even if you are a genius and have a massive amount of free time (hint: forex trading) while other strategies could be executed by anybody with little effort. But being able to differentiate between a good and a bad strategy is also a skill. Some people might stumble on CoBF.com when they start out as an investor and go for some value strategy while other might stumble on a forex trading site and go that route. If your process for choosing a certain strategy is flawed the possible alpha of that strategy is not really your alpha. And if you are really smart and could generate alpha, but go for a passive indexing approach because that strategy sounded more convincing it’s also proof that investing is hard (unless of course it’s a conscious decision but you, for example, go for indexing because you have a lack of time or interest in investing) .

When I started investing I wasn’t at all convinced about my ability to beat the market, but I knew that there was a large amount of evidence that retail investors underperformed their benchmarks by large amounts by structurally buying high and selling low. I figured if they are able to underperform by such a wide margin I should be able to do well by just trying to do the opposite. That’s easier said than done, but on a day like “black Monday” I thought that the correct course of action was pretty obvious: buy stuff when you see ridiculous trading activity. I bought, for example, some Retail Holdings – because that is a stock that I know – at ~$16 because someone was selling at any price and no-one was buying. In some ETF’s there were even bigger opportunities, but I was too late to that party.

There is actually some research that suggests that intelligent investors are better at buying low and selling high. It doesn’t really sound like a surprising result, but it’s not easy to research since your broker usually doesn’t know your IQ. But in Finland nearly every male of draft age is IQ tested, making an interesting paper possible. Especially this graph that shows when people in the 1995-2002 period were buying tech stocks is pretty neat:

Buying/selling in tech stocks during bubble by IQ group

So I think if you are reasonable smart (maybe 120+ IQ?) and have enough time to research strategies and stocks active investment is perhaps worth a shot. I don’t really think that having the right mindset is extremely important because I think that is largely created by having the right knowledge (for example knowing that selling in a panic is almost the worst thing you can do). But I wouldn’t be surprised if many people think differently, and I also wouldn’t be surprised if I’m wrong about this. Anyway, enough rambling. To sum it up; I think that what people should do really depends on their intelligence, education, available time, their personality and probably other factors that I’m missing. There is no strategy that is a good fit for everybody. Indexing isn’t the right strategy for everybody, nor is value investing.

You have to be brutally honest with yourself about what is the right strategy is for you.

13 thoughts on “How hard (or easy) is it to outperform?

  1. Alpha Vulture Post author

    I have now, interesting paper. Also supports my intuitive idea that when there is a large group of people who are underperforming a smart investor should be able to outperform. From the paper:

    This excess performance is extremely statistically significant. Since the average holding period of these investors is approximately six months, investors in the top decile outperform those in the bottom decile by about 8 percent per year on a characteristic-adjusted basis.

    Reply
  2. Phil

    I saw a study showing that 1) average IQ has increased by 15 points in the past 50 years and that 2) Asians have the highest median IQ with negative kurtosis to the normal distribution. Perhaps that would make asians the best investors? It is true that China has a much higher savings rate than US, 50% vs. 6%. I wonder if savings rates are related to investment success? I am not sure that IQ is the best measure of market outperformance, see failure of Long Term Capital. I take IQ tests for fun, my results range from about 90 to 142. My investment results at this point feel like I am borderline moron. Last year at this time I felt like a savant. So it goes.

    Reply
    1. Alpha Vulture Post author

      When I look at the Chinese stock exchange I somehow doubt that they are great investors… LTCM is an interesting case study. Sometimes smart people aim too high/are too confident. But on average being smart works I’d say.

      Reply
  3. krullebol

    Another factor that determines style is employment related compliance constraints. And the ratio of human capital to financial capital seems also pretty important.

    Reply
    1. Alpha Vulture Post author

      If you have compliance constraints you have the wrong job 😉 But sure, that’s a relevant factor for a small percentage of investors. I actually don’t think that the ratio of human capital to financial capital is extremely important. At some point in time, everybody’s human capital will be turned into financial capital. It probably makes sense to figure out what the best strategy is before that happens, since mistakes will be more expensive if you have little human capital.

      Reply
  4. Amir

    The question about buying Low in crash is what do you do if you are fully invested?
    where will you bring money to buy low in Crush/ Corrections?
    Unless you have a strategy to Keep large amount of Cash for years sometimes and deploy them in crash.
    and then what is crush? 10%? 20% 50%
    Does it worth to keep cash on the side when market go up 50% and wait for 10% correction?

    Reply
    1. Alpha Vulture Post author

      If you are 100% invested that’s unfortunate but totally acceptable. But I think in many strategies you almost always have some amount of idle cash. Perhaps because you recently sold a position that hit your fair value target or you invested in a special situation that paid out. Or simply because you got paid some dividends. I certainly wouldn’t advise keeping a large amount of cash just to be able to profit from a possible crash.

      And when you are 100% invested you can still sell something cheap to buy something that is even cheaper.

      Reply
  5. Amir

    i think the best strategy of Fully invested is to re-shuffle in crash
    Some stocks will fall 20% and some 70% and the bounce back might be similar proportion
    the complicated work you need to do is to identify stocks that the bounce back will be stronger than those you sold. one position with the 20% loss and shift for other positions with chances of stronger rebound.

    Reply

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