The Case for Beating the Market, Part 1
Why I have an active investing approach despite the conventional wisdom
Most people shouldn’t actively invest in the markets
It's well understood at this point that most people should hold low-cost, highly diversified ETFs. It's too hard to beat the market, and the so-called professionals with lots of resources and expertise can't do it. So how could anyone else do it?
I generally agree with this advice, and it's what I tell almost everyone I know who asks me what they should do with their money. Most people really shouldn't be trying to beat the market. And I believed the same was true for myself when I first started my career in equity research. In fact, I believed that no one, not even professional (AKA institutional) investors, could consistently beat the market, as it was too hard to beat. This is essentially the view put forth by strong and semi-strong versions of the efficient market hypothesis. As a result, I didn't invest in the markets for the first 5 years of my career.
Who should actively invest, and when
But after enough experience, I started to realize that this wasn't exactly true. I still believed that the markets were sophisticated, and that it was not easy to beat it. But I witnessed situations where I felt the market was wrong about something, and then saw it play out as the stock shot up. I saw where the market was wrong in the deep analysis I did, in my conversations with institutional investors, and in discussions with senior management teams about the investment stories. My conclusion: at select times, there are opportunities in the markets that can be exploited by someone who has the knowledge and insight to take advantage of it. This is more aligned with the weak form of the efficient market hypothesis.
I started investing six years ago with small initial positions in Facebook and Amazon. From there, I gained confidence and started to invest more aggressively. Today, I have a very strong respect for the sophistication of the markets, and I still believe most people should not be actively investing in the markets. However, for those with the right knowledge base and the right effort, it might make sense to try to buy individual stocks in certain circumstances. And given my background in equity research, I view myself as being in this bucket of people.
Why funds often don’t outperform their benchmarks
So why do so many professional investors fail to beat the market, and why would I succeed? I agree that funds often underperform the market, but I would argue that this is due to the nature of managing billions of dollars at scale, and not because it's not possible to select stocks that will outperform on a consistent basis.
As funds get larger in size, it becomes harder and harder to outperform the market. Each individual investment made becomes much larger in size, thereby affecting the stock price more and more. As an example, a multi-million dollar stock purchase in a small to mid-cap name could drive the stock up significantly, thereby reducing the gain on the trade. And with billions in assets under management, funds are then required to spread their investments across many more companies in order to put the money to work. In short, as funds become larger in size, they require more good ideas to invest in, thereby making it more difficult to outperform.
How my approach differs
The biggest difference between my own approach and a fund is that my own portfolio is tiny enough to where I don't need to worry about producing a ton of great ideas; I only need to invest in the three or four where I have the highest conviction. My trades don't move stocks, and only need to fit my own risk parameters. This is a major difference as the quality of my investments don't get diluted over time. Many institutional investors have a few great ideas, and if that was all they had to invest in, I think their performance would look much better.
Secondly, I do view myself as having insight into specific companies that the market does not fully appreciate. While this might sound overconfident, this sort of confidence is required to try to beat the market in the first place. This doesn't mean that I know more than the market for every stock. As I stated previously, I have a strong respect for the market, and I don't have enough insight to know where every stock should be priced. Instead, I focus my time and effort on the few names where my personal experiences and views have led me to spot a market mispricing.
Active investing could make sense for those who are serious enough
For the casual investors who don't have the time to closely watch their stocks or to learn about equity analysis, passive investing is still the best approach. However, for those who are willing to put in the time and effort, I think it’s possible to beat the market. But it requires a serious effort to learn more about the company, the industry, and investing more generally. It also requires a thirst to seek out opposing views, and the intellectual honesty to recognize when you might be wrong. I’ll detail this further in my next post on my investment strategy.