Beating the Market or Faking It?

Here is a story I heard a while back (I have no reason to believe that it's true): a new financial advisor moves into town and wants to drum up some new business. He buys a mailing list and drafts a marketing letter. In the letter he talks about stock XYZ. In 50% of the letters he praises the stock and forecasts that the stock price will go up in the following two weeks. In the remaining 50% he explains that the stock price will go down during the same period.

He mails the letters, waits two weeks and repeats the process, but this time he only sends marketing letters to the 50% of residents who got the version of the original document which turned out to be true, i.e. if the stock went up only the ones that received the positive remarks about the stock receive a new letter, and vice-versa.

If the financial advisor repeats the process four times, each time using a different stock as the subject of his fraudulent letter, at the end of the period 1/16 of the town's population will be convinced that the new financial advisor is a stock picking genius, having guessed the short term performance of four separate stocks correctly with a 100% success rate.

Of course, there are many reasons why this scam would not work. For example, some of the residents could compare notes and realize that conflicting advice was being sent to them. However, this is not the point of the story. My point is that residents who received the correct predictions would have no way of knowing whether the advisor was providing insightful advice or whether he was merely lucky four times in a row. After having received four correct predictions, many of the residents would probably hire the services of the scheming advisor, even though in reality he did not add any real benefit to their investment decisions.

Although this story sounds far fetched, in reality it is something that happens every day. However instead of happening with a single financial advisor, it happens with a hoard of financial planners, brokers, fund managers and so forth. Some say a stock will go up, some say a stock will go down. Some happen to be right. Some will happen to be right four times in a row. Because there are hundreds of thousands of professionals in the financial services industry, some will happen to be right dozens of time in a row. In many cases their success will be based on pure coincidence. The laws of statistics virtually guarantee that some advice givers will be correct a seemingly implausible number of times by pure coincidence.

I concede that there may be a select few whose success is based upon knowledge and expertise rather than luck, but the real question is:

HOW WOULD YOU KNOW WHICH IS WHICH?

So what remains? Index funds. Don't try to out-guess the market. Don't try to outperform the rest of the population. Simply aim for average returns and reduce your costs. Academic studies have repeatedly shown that using this seemingly lackluster strategy will yield a higher than average return.