Most Must Lose

At any given moment, the stock market is basically a zero-sum game. This is a big part of the reason that active portfolio managers have such a difficult time outperforming their benchmarks.

In a recent webinar, Scott Donaldson from Vanguard’s Investment Strategy Group explained how this zero-sum process works against anyone who tries to beat the market:

Start from the premise that every minute of every day the market, or all the holdings in a particular market that are being held by investors, aggregate up to become that market. 

Every [completed] transaction in the stock market or the bond market has a buy and a sell transaction. [On one side is] somebody [who] thinks that they’re going to buy a stock or a security because the forward-looking performance, in their mind, looks to be good. [On the other side], you have somebody deciding to sell that security at a particular price [because] they think there are better opportunities out there. 

So from a performance standpoint, [for] every dollar-weighted excess [positive] return, there has to be a corresponding dollar-weighted excess negative return. So dollars that win have to be offset by dollars that lose. It’s a mathematical certainty and just the way that the market operates. 

All of the active managers out there that say, in their marketing literature, “I’m going to outperform, or we’re going to try to outperform the market.” [Yet], everybody cannot outperform the market. It’s an impossibility based on the zero-sum-game theory. 

[The chart above shows] two hypothetical bell-curve distributions of the returns of the stock market. This curve on the right is the before-cost distribution of the market return. So if you’ll see, the market return here in the middle is the average return for an investor before cost: You have 50% of the dollars outperforming, and you have 50% of the dollars underperforming the market. 

However, in reality, we all know that investors have costs associated with investing. There are expense ratios when investing in mutual funds. In trading individual securities, there are [potential] commissions. There are bid-ask spreads. And one type of cost that a lot of people forget about is actually taxes, which can be a huge. 

So if you think about equal dollars outperforming before and equal dollars underperforming the market from the zero-sum-game frame point [and] add costs in, the distribution of market returns [shifts] to the left. The average investor return after costs is significantly less than the original. Only [the] shaded portion of investors actually outperformed the market after costs. Significantly more than half of investors’ dollars underperform the market on an after-cost basis. 

That is why indexing works because indexing seeks to keep your return as close to {the right center line] as possible by keeping costs and transactions low. The closer you stay to that before-cost, market return line, the more individual investors you’re going to outperform. 

How does that translate to the real world? If you look at the returns of active managers versus their corresponding benchmarks or index funds over the last 15 to 20 years, about 70% of active managers have underperformed their benchmark. That’s a significant percentage. 

Transcript edited for clarity

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