When Sophie was about four years old, her parents took her to see a magic show. She was called up on stage to help the magician pull coloured silk hankies from his ostensibly empty top hat. Sophie reached up on tiptoe to peer inside the hat, and saw that the hankies were coming from a hidden pocket inside the brim. When she pointed this out to the audience, the magician was not best pleased with her!
Do you think magic is real? Some tricks are amazing! But we know they are really just an illusion.
Similarly, some people believe the stock market can be beaten. But that’s a myth.
They think active fund management works. But it’s just gambling with other people’s money and being paid for it.
It might seem that individual fund managers or companies can outperform the market over short periods of time – such as Anthony Bolton at Fidelity (1979 to 2006) – but star fund managers are very rare and the odds of picking one are not very good.
Let’s look at the science…
As long ago as 1900, Louis Bachelier devised the ‘random walk’ hypothesis that showed the behaviour of stock prices is completely random. Read about it on Wikipedia.
More recently, there has been 50 years of academic research conducted on data collated over 70 years. The studies have been extensively peer-reviewed. The results destroy the myth that anyone can beat the market.
Picking stocks is not like “pick a card, any card”. It’s more like picking a whole hand of cards.
The overwhelming conclusion is that you should invest in a portfolio of index funds. Asset allocation accounts for over 90% of the variation in returns of a diversified portfolio. Market timing and stock selection has little to do with it.
Daniel Kahneman, the Nobel prize-winning psychologist and pioneer of behavioral economics, says: “The illusion of skill is not only an individual aberration; it is deeply ingrained in the culture of the industry.”
Todd Schlanger, investment strategist at Vanguard (which runs a number of tracker funds in the UK), said: “In any market, 50 per cent of funds will beat the market and 50 per cent will underperform. When you add in costs, this means the majority of funds will underperform the market over time.”
Remember that whatever you read in the press and see on TV or hear on radio has been generated from within the financial industry – so it’s wise to ask yourself who benefits most from this misguided belief in ‘magic’.