Why Most Portfolio Managers Tend to Underperform The Market Average

Anyone who is in the field of active investment portfolio management understands the pressure of trying to beat the broad market indexes. With so many stocks, bonds, and other financial instruments to choose from, the process of constructing and managing a diverse portfolio is a daunting task. The attrition rate is high; most portfolio managers tend to underperform the market averages.

Hendrik Bessimbinder of Arizona State University has come to this conclusion in a very recent study.

Fifty eight percent of CRSP common stocks have lifetime holding period returns less than those on one-month Treasuries. The modal lifetime return is -100%. When stated in terms of lifetime dollar wealth creation, the entire net gain in the U.S. stock market since 1926 is attributable to the best-performing four percent of listed stocks, as the other ninety six percent collectively matched one-month Treasury bills. These results highlight the important role of positive skewness in the cross-sectional distribution of stock returns. The skewness arises both because monthly returns are positively skewed and because compounding returns induces skewness. The results help to explain why active strategies, which tend to be poorly diversified, most often underperform.

That’s right – just four percent of U.S. stocks since 1926 have been responsible for 96% of the gains in the U.S. stock market. The fact that the other ninety six percent effectively matched the return of Treasure Bills – deemed to be the safest and least lucrative investment – is quite remarkable.

For anyone who is knowledgeable about fat tails, power laws, and the Pareto Principle, however, this conclusion should not come as a surprise. Stock market returns, like natural disasters, monopolies, pandemics, the distribution of wealth, and terrorist attacks, don’t confirm to normal distribution models. The returns on the stock market don’t cluster around the mean the way height, weight, blood pressure, IQ, or the grades of university students, does.

With this knowledge in mind, we can logically deduce that most attempts to create a well-diversified investment portfolio are doomed from the start. The portfolio manager (or individual investor picking stocks in his pajamas every morning, thinking he can outsmart Wallstreet) is, invariably, not going to be diversified enough to capture a piece of the positive skewness associated with the few stocks that produce the majority of the gains in stock market.

It would be an extraordinary onerous task on the part of the stock picker to collect, evaluate, and synthesize the endless streams of market data pouring in, and use it to correctly select those stocks that will produce these colossal returns. Given the limited time and resources of the stock picker (and the fact that it’s probably an impossible endeavor), he would simply guess at some point, and use his fancy charts, ratios, and “seasoned intuition,” to rationalize his choices.

The truth is he would have to be quite lucky, but he will never admit this – and neither will the mutual fund sales representative at your bank, who will utilize every sales tactic to convince you that investing in their funds will help you earn enough money to retire comfortably at age 55.

Do you now see why the return on your equity mutual fund or balanced mutual fund that you have locked away in your RRSP has produced such a meager return?

If you think that a portfolio of 50 “professionally selected” stocks is sufficient to produce annualized returns of 7% over a decades long time horizon, you had better think again.

The conclusion of this study emphasizes the critical importance of diversification in portfolio construction. It  reinforces the views of those who promote index funds as the all-round best way to invest money in the stock market. After all, if you allocate your money among all the stocks in the stock market (theoretically, as index funds don’t invest in absolutely every stock), you are guaranteed to be exposed to the abnormally positive returns of the few that will generate the greatest return. It matter little that you’re simultaneously exposed to a myriad of stocks that will, inevitably, prove to be losers; the returns produced by the winners will dwarf those losses and earn you a positive return over the long run.

Though index funds have their shortcomings, there is a great deal of evidence to suggest they might be the best way to have your money work for you in the stock market. The average person, it seems, has little to gain by investing in actively managed funds.

For some tips and strategies on constructing passive investment portfolios, visit Canadian Couch Potato.

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