This post was first published in May 2020 and updated in March 2021
The biggest refrain you hear from people who think you can beat the stock market goes as follows:
“By definition, 50% of investors do better than the market and the other 50% do worse. Surely it cannot be so hard to be in the first group.”
There are a few problems with the above statement.
First of all, the actual proportion of investors that beat the market is far less than 50%. Here’s why:
Assume there is a $1m trade in Apple shares. On one side of the trade, you’ve got a thousand retail investors, each selling a share of Apple for $1k (yes, I know Apple is just north of $100 at the moment after all the stock splits but let’s keep it simple).
On the other side, you’ve got an institutional investor with $1m of capital, buying those 1,000 shares.
If Apple outperforms the market, the institutional investor will have beaten the market, while all the individual investors will have underperformed.
In terms of money traded, the split is 50-50. There was a cool million changing hands on each end.
But in terms of investors, the split is 0.01% winners to 99.9% losers. Sure, it could also be the other way around.
Except it isn’t, as you will see further down below. When it comes to active investing, retail investors rarely beat professional money.
Second of all, no one questions the fact that some people can beat the stock market. That happens every minute, hour, and day.
The question is, can you outperform the market on a consistent basis?
Or is it Adam getting lucky today, Joe tomorrow, and Jenny next week, yet all of them lose money over the long run?
As the data proves, doing so over years and decades is much harder than scoring a few lucky shots:
Not as easy as it appears
And yet, some people do beat the stock market. Over the years, I’ve come across a number of them, which I can broadly bucket into four categories.
Let’s take them in turn.
The People Who Beat The Market
Category #1: Insider Traders
This is the easiest one.
Notwithstanding all the technological progress in tracking illicit activity, insider trading still happens, as evidenced by the data.
Source: Patrick Augustin, Menachem Brenner, Marti G. Subrahmanyam, University of Montreal
In the graph above, T-0 is the moment in time when inside information becomes public knowledge.
That pesky line creeping up? That’s all the naughty people who have the inside information, know they aren’t supposed to trade on it – and do it anyway.
According to the evidence above, quite a few also manage to get away.
Make no mistake – this is not a victimless crime.
Insider traders are people who literally reach into your pocket and appropriate a share of your investment returns.
They bid up share prices of the winners – and so by the time the rest of the market (i.e. you) gets around to buying, they end up paying a higher price and getting a lower return.
And they short sell the losers – so by the time you get around to selling your stock, you absorb a bigger loss.
Some insider traders take this to the next level.
No, he isn’t going to a party
One gets a ten-year sentence, the other – a minority stake in the New York Mets.
Whatever the circumstances, seeing “investors” like these eradicated as a class ranks pretty high up on my wish list.
Category #2: High-Frequency Traders
As it turns out, starting in the early 2000s, another group of investors figured out a way to beat the stock market.
They managed to keep it on the down low for a long time – until Michael Lewis caught wind of them and wrote an excellent expose titled Flash Boys.
In a nutshell, high-frequency traders (HFTs) set up infrastructure as close to stock exchanges as follows. By getting an earlier look at all the buy and sell orders in the market, they can figure out which way the prices are heading.
They then jump in, buying and selling stocks before the price moves – and selling them right after.
You can think of HFTs as a bunch of lightning-fast piranhas swimming next to a freshwater bull shark.
No matter how formidable the bull shark may be, piranhas will jump on prey much faster, leaving the bull shark with leftovers.
Reminds you of anyone? Not that different from insider traders, are they… The word frontrunning also comes to mind.
Founded by Ken Griffin, Citadel Securities is probably one of the most famous HFT shops in the world, but there are many others.
Despite all the recent spotlight and the talk of regulatory intervention, they still operate in broad daylight. I suppose the most expensive real estate in the world doesn’t pay for itself.
Ken Griffin’s latest real estate purchase here in London
Sorry to say this, but the bull shark is you.
Category #3: Fundamental Investors
Of everyone who manages (or claims to) beat the stock market, this is perhaps the most high-profile group.
Hundreds of thousands of highly educated, intelligent, and motivated individuals spend their days and nights analyzing companies to discern the winners from the losers.
Some succeed – but most don’t.
For those that do crack the code, it may be a case of skill – or yet more evidence of the Infinite Monkey Theorem.
Unfortunately for star-struck investors, even the most successful money managers tend to flame out after a period of time.
Neil Woodford (though he says he’s sorry and wants to try again), John Paulson, Bill Miller. Even Bill Gross crashed and burned in the end.
And many of the ones who didn’t (Peter Lynch comes to mind) simply operated in very different market conditions.
No one wants to admit it now, but in an era of less stringent disclosure requirements, they often had an informational edge over retail investors.
And yet, the likes of Graham, Buffett, Soros have a well-deserved place on the pantheon of the greats. New faces may well join them over time.
The only challenge is figuring out who they might be – ahead of time.
Category #4: Quantitative-Driven Hedge Funds
And now, let me introduce you to the Moby Dicks of the stock markets.
Keeping a low, almost invisible profile, they lurk beneath the surface, using powerful supercomputers and bleeding-edge algorithms to identify and exploit stock market inefficiencies.
It could be predicting the price of crops based on daily weather patterns for the preceding year.
Tracking container ship movements to bet on exchange rates.
Scraping corporate job advertisements to predict R&D progress and forecast new product launches.
Day after day, they run correlations on thousands of variables to try and discern even the weakest cause-and-effect relationships which are all but invisible to the human eye.
In his lengthy, yet excellent book The Man Who Solved The Market, Gregory Zuckerman lifts the veil on this secretive space.
For those of you who enjoy peeking behind the scenes, this will be a worthwhile read.
It’s fair to say that Renaissance didn’t seek the spotlight.
If anything, they tried their best to avoid it – but thanks to Zuckerman’s dogged reporting, we now have an excellent view into what it takes to crack the stock market – and how lucrative it can really be.
Meet the man who actually did solve the markets (courtesy of WSJ)
Here’s a piece of data to drive the point home: between 1988 and 2018, Renaissance generated an annualized return of 66%.
Yes, you read that right.
66% on average, or a total of $104 billion in trading profits over 30 years.
Even after Renaissance’s eyewatering fees (5% management fee and 44% of the profits), it worked out to 39.1% in annualized returns to investors.
While I’ve never met Jim Simons, I have come across a few of his contemporaries.
After all, even the most secretive traders can’t run their business without accessing the markets, which they typically do through broker-dealers.
My perceptions of the industry certainly jive with what Zuckerman has to say. For those of you who don’t feel like going through an entire book, these are the most salient points:
The people involved are incredibly smart
World-class mathematicians, military codebreakers, physicians, astronomers, and statisticians, the players here aren’t your typical Wall Street types.
And yet, they possess exactly the right skills needed to beat the stock market in today’s incarnation.
They have access to world-class infrastructure
Hundreds of millions of dollars are invested every single year to upgrade the machinery that helps collect, process, and analyze the information – on a near real-time basis.
They don’t try to make sense of the market
The most successful quants have long realized that they cannot explain most of the correlations they identify.
They don’t look for underlying answers. If the relationship is statistically meaningful, they trade on it and move on.
Their success rate is just north of 50%
This is perhaps the most startling revelation of them all.
For all their intellectual ability, experience, data sets, and capital, the odds are just ever so slightly in their favour.
Yes, it’s this hard to beat the stock market.
Unfortunately, when something seems to be too good to be true, it probably is.
No, Renaissance and other quant hedge funds aren’t running a Ponzi scheme of some kind.
The answer is much more prosaic is much more disappointing.
They Don’t Need Your Money
Yes, this is the biggest letdown of them all.
When the quantitative hedge funds were just starting out as an investor class, they did accept outside investors.
The issue, of course, is that market inefficiencies are hard to find. And when you do find them, the very act of exploiting them reduces the arbitrage opportunity to zero.
You can’t milk it forever. If you could, Renaissance wouldn’t have paid out $100bn+ in dividends.
Instead, they would have reinvested the money and dominated the entire world instead of just lurking in the corridors of power of its most powerful country.
As their trading profits piled up, the quant shops realized they are much better off keeping the spoils to themselves.
Today, access to the best funds is limited to existing and former employees only, plus a small club of privileged insiders.
And yes, this applies to anyone else who figured out a way to make a superior risk-adjusted return.
I hope that people reading this blog know this already, but just in case, here goes:
No, that Instagram bro with pics of cars and mansions in his profile doesn’t know how to do it.
Neither does the Twitter “expert” with proprietary option trading courses that you can buy for £99 (but only if you hurry up).
And nor do the Facebook “commodity visionaries” that seem to have overtaken my timeline with sponsored posts on crushing it with gold through the next debt supercycle.
The only thing they’ve figured out is how to speak to that ever-present human desire to find a shortcut instead of taking the tried and tested route.
The problem is, despite anything you may have seen on the internet, you only have two possible paths to riches:
If you are a world-class scientist with a stellar track record, you may want to chuck in a job application here.
Everyone else might as well stick with index funds.