It is OK to be Average
Key Takeaways
Getting a good investment outcome is not about getting a leg up on the competition.
The immense volume of market trading everyday equalises any proclaimed edge that an individual may claim to have.
Making investment decisions in response to any piece of news is a bad idea, as the market would have reacted faster than you can respond.
In addition, studies have shown that superior intellect (measured in IQ) does not lead to superior investment outcomes (quite the opposite in fact).
You don’t need to beat the market, do over-leveraging, or pick the best stock to be rich. You just need to earn a decent rate-of-return and let your money compound overtime.
— Naved Abdali
In almost every other undertaking in life, everyone can broadly agree that people with above-average skills would likely produce above-average results. This rule of thumb generally holds true whether in studies or sports. It is interesting though that when it comes to investing, being skilful or smart does not necessarily lead to good investment performance.
Novak Djokovic can be considered the best tennis player of all time. Nobody would say that it was pure luck that he managed to win a record of 23 Grand Slams, and his success was likely due to him being a very good all-rounder. Although he had struggled in some aspects early in his career, getting better at some of his weaknesses helped him evolve into a world-class champion. When comparing individual skills, Ivo Karlovic had one of the best serves, Rafael Nadal was the best clay court player, Roger Federer was the best grass court player, Juan Martin Del Potro had the best forehand, etc. Whilst not the best in individual skills Djokovic was definitely above average in many of these areas, and that allowed him to succeed.
Skills? Not So Much.
One of the key distinctions from investing is that in most sports, you pit yourself against a select group of individuals. In investing, many investors make the mistake of believing that they are in a game pitting themselves against each other. Professional money managers compare their performance with their peers, as if in a competition to always trying to outwit each other. Retail investors act on “hot tips” or “inside information” in order to get a leg up on the next investor.
In reality, what happens in markets everyday is that each person buying or selling an asset is using the market to serve his or her own self-interest; from the day trader trying to make a quick profit, to the pension fund buying with a 30-year timeframe. As a result, the market prices reflect each person’s own information and analysis, coming to an equilibrium — like a giant weighing scale. As a result, investors who think they have some insight as to what the actual price stocks should be, are likely deluding themselves.
The diagram above shows the value of daily trading which occurs around the world every single day. Whether you are an investor trying to place a ten thousand or ten million dollar trade, the occurrences that happen every single day dwarfs your investment size and the conclusion you came to when you decided to act. You really are competing against the entire world who may have even better information or resources than you.
On Top Of The News?
If you feel that keeping updated on the latest happenings in the world will help you invest better, think again. Information flow is so fast these days that any unexpected news is nearly instantaneously reflected in market prices.
For instance, in 2012, the morning’s breaking news was about imported oranges having a potentially dangerous fungicide. Almost instantly, the price of orange juice futures jumped nearly 10% as investor expectation was that there would be a shortage of oranges because of the affected supply. So even if you were checking your news updates by the minute, it would be very hard for you to jump on the trade in time. And if you were an investor in Dec 2011 looking for something to buy, would you have expected such a large spike the following month?
Mental Acuity?
While it is possible that smarter people do invest better, a host of data and research suggests otherwise. First, a study on investment clubs showed that the average club and its members lost around -3.8% of performance compared to if they had just diversified broadly and sat still. Investment clubs are usually led by experienced traders and investors who share their best ideas and theses with the members. The main culprit for the underperformance was lack of diversification and trading cost.
But what about special clubs only for people with high IQ? Surely the Mensa society (which only admits individuals who score at the 98th percentile or higher in an IQ test), should be able to have members who can analyse markets and consistently invest well? The June 2001 issue of Smart Money reported that over the past 15 years, the Mensa investment club returned just 2.5%, underperforming the US market (S&P 500) by almost 13% per year. An investor who had been a member of the club for thirty-five years, reported that his original investment of $5,300 had turned into $9,300. A similar investment in a broadly diversified US market strategy would have produced almost $300,000. Another investor described their strategy as buy low, sell lower.
The Issues
The problems with trying to be above average in investment performance boils down to allocating at the wrong time — additionally, allocating to the wrong investment at the wrong time. Behaviour and emotions are more important to investment success than intellect or skills. Studies over the years (chart below) show that most investors tend to be swayed by emotions and get in and out of the market at the wrong time — instead of holding on for the longer term.
The other problem other than getting in and out at the wrong time is when investors try to pick supposed stock market winners in an attempt to boost their returns. Sure, sometimes you might get it right, but very often you would get it wrong. The chart below shows the difference in performance from holding a diversified investment versus one where you missed holding some of the top performers for the period. As an example — after the tech bust of 2022, would you have thought to buy Nvidia in Jan 2023?
For investing, it is ok to be average. You really don’t need to have a special skillset, the latest financial news updates, nor have higher than average intelligence. All you need for investment success is a broadly diversified investment portfolio, and a well constructed investment plan to keep your emotions in check.
If you want a second opinion on whether you are on the right path, come and have a chat with us.
