Wednesday, January 23, 2019

Odds of beating the market over many years -- continued

An earlier post shows just how difficult it is to beat the market over many years.

For instance, with a 45 percent chance of beating the market over one year, the probability of beating the market 9 or more years out of 12 is small -- just 36 times out of 1,000, or 3.6 percent (add the probabilities for 9, 10, 11, and 12 years in the figure below). And beating the market 11 or more years out of 12 is truly comically tiny -- just 11 times out of 10,000, or 0.11 percent.


You may object to my 45 percent assumption, but this is roughly the (optimistic) probability of a mutual fund beating the market in a given year. Here's some proof.

In the 1996 edition of Burton Malkiel's exceptional book, "A Random Walk Down Wall Street," he states:

"Over the whole 22-year period since the first edition of this book, about two-thirds of the funds proved inferior to the market as a whole. [Thus the probability of beating the market (or equaling it) is about 33 percent. To be fair, I am not entirely sure whether this is per year. Nor am I sure of the type of return calculation.]"

However a nearby graph in his book gives plenty of detail. In the graph, Malkiel shows the probabilities of the broad market beating the typical general equity fund for each of the last 22 years. Averaging the values over the 22 years, 1973 through 1994, I get a 56.6 percent probability of the market beating the funds each year or a 43.4 percent of the typical general equity fund beating (or equaling) the market each year.

Thus, the 45 percent assumption is not silly.


In fact, as the markets have become more efficient, I suspect this 45 percent assumption gives fund managers ample benefit of the doubt. For instance, you will often read that only 25 percent, or so, funds beat the market in the current year.


I do not know the statistics for the individual investor but I suspect 45 percent is being quite generous. In fact, typical investor performances in mutual funds have badly trailed the already shoddy performance of the funds. In other words, the typical investor underperforms the typical mutual fund -- most likely because of the usual culprits, namely, greed and panic asserting themselves at precisely the wrong times.


Finally, one last point. Some may argue it is the total compound return that matters over many years not how many times someone beats the market. That is certainly true but just remember generating 40 percent one year, far above the market (say), usually implies weak returns the next few years. And because of how investors behave, jumping in at the tail end of the 40 percent, then holding the fund for the next few years, net, they get killed.

Ideally, what you want is consistent returns just above market with moderate risk. Do that and you make a killing.


So the next time someone tells you they beat the market, ask them how many times they have beaten the market over a long period. Only then will you get the honest truth -- in my opinion, 70 or 75 percent of the time over a long period is evidence of an extremely strong strategy and performance.

This isn't easy.



The portfolio in "Investing in Dividend Growth Stocks" has beaten the market 11 times out of the last 12, and really 12 times out of the last 13 years, or 92 percent, a record that is matched by no more than a few, if any, (general purpose) mutual funds over this period. Available on Amazon, and

The portfolio in "Dividend Growth Whisperer," published in October, 2018, handily hammered the market in the fourth quarter of 2018. The portfolio in this book is an update to the portfolio in "Investing in Dividend Growth Stocks." It also presents a novel (and simpler) variation of the crucial concept of valuation. Available on Amazon,

The latest edition of "A Random Walk Down Wall Street,"

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