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Many individuals believe they can make significant quantities of money by stock trading. Much of the financial services industry wants the public to believe that it can take our savings and, by the application of investing skill, make better returns than the market average. Much of the advertising for mutual fund investment vehicles in the UK touts superior past performance despite the (legally mandated) small print asserting that past performance is no guide to the future.

For example, a UK mutual fund house, Jupiter, describes it mission thus:

We are an active fund manager seeking to add value for our clients through the delivery of investment outperformance over the medium to long term.

There are even two major schools of thought about how to achieve good returns:

The problem is this: there is a solid body of financial theory that asserts that long term outperformance based on any form of market analysis is impossible. The Efficient Market Hypothesis asserts:

one cannot consistently achieve returns in excess of average market returns on a risk-adjusted basis, given the information available at the time the investment is made

(unless, it is worth adding, you have inside information on which it is illegal to trade in most markets). Burton Malkiel's famous book on the topic, A Random Walk Down Wall Street, is a very readable introduction.

As a test of investing skill more than one experiment has been conducted pitting the professional stock pickers against random choices (often vividly illustrated by having a monkey throw darts at the Wall Street Journal to select a portfolio). Experts often don't do significantly better than random. As a Forbes article reports, when the Wall Street Journal did the random-selection experiment:

On average, investors following the experts’ recommendations lost 3.8% on a risk‐adjusted basis over a 6‐month holding period.

Both the theory and this experiment seem to defy common sense. How can people who a skilled and well paid for their skill not actually consistently beat a random number generator? How can such a large industry exist when the skill they assert is impossible to demonstrate?

So the question here is: is there evidence that experts can consistently beat the market? Are there demonstrable strategies to make returns ahead of the market average?

Oddthinking
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matt_black
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    From my experience while working in investment banking, for pros it's more about reducing risk using hedging, diversification etc. rather than picking one best stock. And there is also a reason why traders are in from 7am to 10pm, they have to react to changes, not pick stock for 6 months in advance. – vartec Oct 11 '12 at 10:26
  • Related question: http://skeptics.stackexchange.com/q/3315/23 – Oddthinking Oct 11 '12 at 10:46
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    The cited article (3.8% loss) does NOT support the claim that the experts are poor at their job/worse than random. It supports the idea that the wide publication of tips from experts respected by naive investors leads to temporary market artifacts, and hence that the markets are (*gosh!*) not always 100% efficient. – Oddthinking Oct 11 '12 at 11:02
  • @Oddthinking Your edits are mostly clarity-improving, but I think you should have left the monkeys in the title: the current title is *dull*. And the monkey example is a well known metaphor for random selection so not actually misleading. – matt_black Oct 11 '12 at 11:11
  • @Matt: Maybe I am being too sensitive, sorry. It came across at first glance as ad hominem. I think you'd agree if it said "Are investment managers any better than smelly, louse-infested monkeys?" that would be going too far. Where the line is being intriguing and too far is probably debatable, and I apologise if I was too cautious. – Oddthinking Oct 11 '12 at 11:58
  • @Oddthinking I'll restore the metaphor in the title. – matt_black Oct 11 '12 at 12:17
  • @vartec Whatever it is traders think they do, the recent banking crisis suggests their strategies, however successful in good years, are capable of losing more than their bank's entire accumulated profits over decades in one bad patch. – matt_black Oct 11 '12 at 12:21
  • @matt_black: can they really? AFAIK, the cases when it occurred, where when traders circumvented safety protocols. – vartec Oct 11 '12 at 12:29
  • Is Warren Buffet just lucky? – RedGrittyBrick Oct 11 '12 at 13:17
  • @vartec I wasn't thinking of the losses from rogue traders (sometimes $billions, but not usually enough to destroy a large bank). I was thinking of the accumulated positions in derivatives such as mortgage backed securities which, when they went bad, were large enough to destroy many major banks had governments not chosen to bail them out. – matt_black Oct 11 '12 at 14:09
  • @RedGrittyBrick If we knew the answer to that we'd have a good answer to the question... – matt_black Oct 11 '12 at 14:12
  • @matt_black: well, **the whole market crashed**, which doesn't mean, that they weren't traders, which did better than market average. Don't forget that underlying problem was the housing bubble, which wasn't caused by investment banking. – vartec Oct 11 '12 at 15:37
  • Great question! I think a more interesting experiment however would be replacing the dart monkey with a casual amateur stock trader. Somebody who knows enough to understand how picking stocks works, but not necessarily how to best analyse performance graphs and evaluate earnings potential. Play money isn't risky enough, so the stocks will be out of date and the future performance predetermined so that when they make a poor pick they get an uncomfortable electrical shock. When they do good they gift cards or coupons. This will simulate risk/reward in real life. – maple_shaft Oct 11 '12 at 16:49
  • A random walk down wall street actually shows that active managers earn superior returns to random stock picking (suggesting there does exist some skill); however AFTER transaction costs their return to investors is negative, making them a bad investment on average. – Jase Nov 30 '12 at 12:52
  • This experiment has been repeated on [Norwegian TV](https://twitter.com/RobinWigg/status/1218146789947334667?s=20) by pitting the professionals against an astrologer, some beauty bloggers and cows shitting in a field marked by gridlines. The Cows equalled the professionals and beat the astrologer but the beauty bloggers beat both despite a complete lack of knowledge about the firms whose stocks they traded. – matt_black Jan 17 '20 at 16:40

2 Answers2

9

is there evidence that experts can consistently beat the market?

Yes, there is. It's quoted in the Forbes article you provide as a source.

To answer this question, Fama and French compared the distribution of fund returns to a distribution of simulated portfolio returns formed with randomly selected stocks. Using a bootstrapping technique, they created thousands of simulated U.S. equity portfolios that selected stocks randomly. The range of actual mutual fund returns was then compared to the range of bootstrapped returns. The overlay was very close, which means most actual fund returns were a result of random stock selection and not skill.

There were, however, a handful of funds whose managers outperformed the bootstrapping method after adjusting for costs and risks. These so-called outliers may possess skill, if only they could be identified.

Above references a research paper "Luck Versus Skill in the Cross Section of Mutual Fund Returns".

vartec
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    adjusting for risk seems like it may be just as likely to confound results as clarify them – Ryathal Oct 11 '12 at 14:36
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    How many are a handful and out of how many funds that were analyzed? If i flip a coin ten times then on average 1 out of 1000 people gets it right 10 times in a row, still doesnt make him an expert. See [Memory errors and biases](http://en.wikipedia.org/wiki/List_of_cognitive_biases#Memory_errors_and_biases). Plenty of these that will magnify the effect. It reminds me a bit off the [rock-paper-scissors competitions](http://www.rpscontest.com/). There is no strategy that can beat a pure random strategy, but they can perform better than other strategies. – Stefan Oct 11 '12 at 15:55
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    The trouble with that Fama and French result (that there are a small number of outliers who outperform) is that it doesn't help ID them in *advance* of the performance. Also the real headline is that *the vast majority of skilled professionals do not demonstrably perform better than chance*, which should be a shocking result. – matt_black Oct 12 '12 at 16:54
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    I'm curious to know the time frame of the study. Did the handful who outperformed do so consistently over a prolonged period, or was this a short-term comparison? I've read (don't recall where) that the best-performing funds are not consistent year to year, and that eventually everything regresses to the mean. That suggests that one promising investment strategy would be to invest in the poorly performing funds, as they are likely to improve over time. – Mark Oct 13 '12 at 14:47
  • It is also possible that the outliers were involved in inside trading... – Kip Oct 17 '12 at 18:16
  • A proper scientific study would be quantitative about the probability that the outperforming funds were purely the result of chance. So I would say this article does not constitute evidence in favor of the claim. – FrankH Oct 18 '12 at 09:59
  • "if only they could be identified." - Google "Fund of funds". – user5341 Nov 30 '12 at 15:19
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There is a problem with Mutual Funds. When the market declines, some people unload the funds and the manager has to liquidate to give them their money, i.e. sell into a declining market. Conversely when markets are climbing, the managers have to invest the incoming cash into the climbing stock prices.

This is a structural disadvantage to MFs, in addition to the drag from fees.

There are 1000s of references to this problem. Here is one:

http://www.bogleheads.org/wiki/Mutual_funds:_additional_costs

Sorry I am new here and just adjusting to your rules.

Keith Cowan
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    Thanks for trying to improve your answer. A couple of tips: You can edit your existing answer, rather than posting a new one. You have dealt with the lack of references, but there is still the problem that it doesn't address the question. You have said there is a problem with Mutual Funds, but you haven't answered: do experts beat the market? – Oddthinking Feb 06 '15 at 22:59