Investing is a zero-sum game, according to Nobel Prize winner William F. Sharpe. In other words, there is a winner for every loser.
When that theory is applied to the market as a whole, logic dictates some investors will out-perform the market while some will under-perform. The issue is one of consistency. Can an investor pick winning stocks year after year?
There are typically two schools of thought when it comes to investing philosophies, but a third strategy is gaining traction among informed investors.
When people talk about playing the stock market, they are most likely talking about active management. Active management has two critical components: stock picking and market timing. To out-perform the market, you have to believe that there are stocks where the price differs from its underlying value and that you can identify these stocks, time both the purchase and sale of these stocks and incur minimized transaction fees.
You also have to do all of this in a tax-efficient manner.
Dozens of academic studies indicate active management is a fool’s game. Included in the group are Nobel Prize winner Eugene Fama and legendary investor Warren Buffet. These iconic economic thinkers argue that you are better off accepting average market returns over time, a strategy referred to as passive management.
A third approach we call evidence-based investing is championed by Fama and Princeton University Professor Kenneth French and recommends utilizing academic research to make informed investing decisions.
Academic research indicates you can earn a higher expected return by diversifying your portfolio and considering company size and investment style in the portfolio design. And new studies indicate that momentum and profitability play a role in quantifying market returns and should also be considered in the portfolio.
Many mutual funds, money managers and brokerage firms have built a loyal customer base by convincing the public that active management works and that their house has the experts who can pick winners in the stock market year after year.
Unfortunately, the data proves otherwise.
Fama and French published data indicating that only 3 percent of active managers out-perform their benchmarks over multiple periods. And when you consider the fees that are paid to these managers, the percentage drops to zero.
On a semi-annual basis, Standard & Poors publishes the SPIVA Scorecard, an evaluation that indicates the number of active managers who are “beating” the market averages. The SPIVA scorecards show the same under performance of active managers — fewer than 7 percent of active managers maintained top-half performance from 2010-2014.
Think about that for a moment: The managers in these studies are ostensibly the best of the best, graduating from the top business schools and working for the heaviest hitting funds. And for this underwhelming performance, clients are frequently charged high fees.
Even if you do get lucky enough to find an investment guru who can outperform the market, are you still getting what you want from your investments when costs are factored into the equation?
What do you get by switching to a passive approach? You get average market returns with no effort and considerably lower fees. This is what Warren Buffet meant when he recommended in his annual report that his trustees invest in Low Cost Index Funds.
Let’s take Buffet’s recommendation a step further toward Fama’s research, which indicates that long-term investors utilizing an evidenced-based approach can expect to see higher than average results by tilting their portfolios toward factors that historically have produced expected higher values.
Maybe most importantly, these results can be achieved in a low-cost, efficient manner.
As a CPA who’s been practicing for more than 30 years, I would be remiss if I didn’t mention income tax ramifications. Income taxes can be a major drag on performance return, and you should carefully choose which investments go into taxable accounts and which go into tax-deferred retirement accounts.
Not all investments are income tax neutral. If you put the wrong investment into an account, you can end up paying Uncle Sam more than he’s due.
By avoiding high priced stock pickers and applying an evidence-based approach that considers the vast trove of academic research, you can win the investing game.
Steven M. Arkin, CPA, is the managing member of Arkin Financial Advisors, LLC, a registered investment advisory firm and a member of the BAM Alliance. Contact him at sarkin@arkinfa.com.