Beating the Market Part 2 – Short-Term Under-performance

Q – How concerned should we be about the cyclical performance of fund managers or of our own portfolio?

A –Performance differences, relative to a market benchmark, don’t really matter over the long-term. Short-term (months or years) underperformance is a fact of life if you are trying to beat the market.

Investors are better off investing in an index fund if they can’t deal with this fact. Otherwise, with human behavior being what it is, investors who can’t accept this fact will buy high and sell low –destroying their wealth in the process.

Volatility and the cyclical performance of active management (i.e. investors trying to beat the market) are really blessings in disguise for long-term investors. This might sound strange but it’s true.

Columbia Business School professor and successful investor Joel Greenblatt explains why in his excellent book: The Little Book that Still Beats the Market.

The point is that if the magic formula* (MarketFox: or any investment strategy for that matter) worked all the time, everyone would probably use it. If everyone used it, it would probably stop working. So many people would be buying the shares of the bargain priced stocks selected by the magic formula that the prices of those shares would be pushed higher almost immediately. In other words, if everyone used the formula, the bargains would disappear and the magic formula would be ruined!

That’s why we’re so lucky the magic formula isn’t that great. It doesn’t work all the time. In fact, it might not work for years. Most people just won’t wait that long. Their investment time horizon is too short. If a strategy works in the long run (meaning it sometimes takes three, four, or even five years to show its stuff), most people won’t stick with it. After a year or two of performing worse than the market averages (or earning lower returns than their friends), most people look for a new strategy— usually one that has done well over the past few years.

As Greenblatt points out, if identifying good investments is easy, everyone would do it and soon there would be no investment opportunities left. The market would then be efficient and by definition it would be impossible to beat.

Fortunately we don’t have that problem. Every long-term investment strategy – even the most successful strategy – will experience periods of poor performance.

This is both desirable and necessary. Periods of poor performance relative to the market create a fresh crop of opportunities; but only for those who are patient and disciplined enough to maintain a long-term perspective.

Investors that would like to try to beat the market need to come to terms with this fact. Otherwise, they will be much better off investing in an index fund.

Even the legendary Warren Buffett is not immune to under-performance. As of the end of 2013, Berkshire Hathaway’s five-year rolling returns (defined by Buffett as book value gains), failed to outperform the rise in the S&P 500.

The sad fact is that investors invariably lose their patience, give up and sell out. Fund managers also capitulate and give into the pressure to change their strategy, as Greenblatt explains.

Even professional money managers who believe their strategy will work over the long term have a hard time sticking with it. After a few years of poor performance relative to the market or to their competitors, the vast majority of clients and investors just leave! That’s why it’s hard to stay with a strategy that doesn’t follow along with everyone else’s. As a professional manager, if you do poorly while everyone else is doing well, you run the risk of losing all your clients and possibly your job!

Many managers feel the only way to avoid that risk is to invest pretty much the way everyone else does. Often this means owning the most popular companies, usually the ones whose prospects look most promising over the next few quarters or the next year or two.

Once again, we have another example of the principal and agent problem at work!

Beating the market is a paradox: to win over the long-term you have to be prepared to accept that sometimes you will under-performover the short-term.

Most investors and fund managers are temperamentally unable to do this. Instead, they fool themselves into thinking that they can beat the market by investing the same way as each other, by investing in portfolios that are over-diversified or that have a high degree of overlap with a market benchmark. The result, no surprise, is that they underperform after fees, costs and taxes.

In their research paper The bumpy road to outperformance, Vanguard examined the performance of 1540 actively managed US mutual funds that were available at the beginning of 1998. They compared the performance of these mutual funds with that of their benchmarks over the following 15 years and found that.

  • Only 55% of funds survived the entire 15 year period.
  • Nearly 700 funds merged or liquidated.
  • Only 275 or 18% of funds both survived and outperformed their benchmark.

But the most interesting result concerns the 275 fund that did beat the market. 97% of them underperformed for at least 5 years. In other words, virtually all of the funds that beat the market spent at least 33% of the time trailing the market!***


Vanguard highlights this fact as evidence that it’s impossible to select in advance a fund that will outperform, as even successful funds experience poor performance relative to the market.

Another possible interpretation is this: Even 5 years of under-performance relative to the market isn’t enough to prevent a good investment strategy from beating the market over the long-term.

Ironically, the conclusion drawn by Vanguard appeals to the short-term thinking of many investors. They would rather give up on beating the market over the long-term in order to spare themselves the psychological and financial pain of short-term underperformance.

Beating the market requires investing in a way that’s different to the market**. However, the future is uncertain and unknowable. Consequently, investors can’t reasonably expect that they’ll always be able to beat the market in the short-term. That said if investors stick to an investment strategy that’s based on sound principles and has been proven to work in the over time, they should do well over the long-term, despite periods of short-term underperformance.

Of course, the fact remains that 82% of US mutual funds in the Vanguard paper underperformed the market. How can investors identify beforehand the 18% that can beat the market? The answer to this question deserves a post of its own. I will write about this shortly.

Vanguard is correct in pointing out that nobody can tell in advance which funds will beat the market in any given year. Clearly this has to be true, since even legendary investors such as Buffett experience short-term underperformance. But that doesn’t necessarily mean that it’s impossible to identify an investment approach that will work over the long-term.

In many respects investing is similar to sport. Even the best athletes and sporting teams lose at times. But does that mean that they should simply abandon their training methods, strategy and tactics? Or, does that mean that their fans should give up on them?

Once again, Greenblatt has some helpful advice.

Even superior investment strategies may take a long time to show their stuff. If an investment strategy truly makes sense, the longer the time horizon you maintain, the better your chances for ultimate success. Time horizons of 5, 10, or even 20 years are ideal.

Though not easy to do, even maintaining a three- to five-year horizon for your stock market investments should give you a large advantage over most investors. It is also the minimum time frame for any meaningful comparison of the risks and results of alternative investment strategies.

Sadly most people don’t invest this way. They lack patience and expect their investments to constantly increase in value.


The following article from the Wall Street Journal provides an extreme example of investors behaving badly.

Best Stock Fund of the Decade: CGM Focus

Meet the decade’s best-performing U.S. diversified stock mutual fund: Ken Heebner’s $3.7 billion CGM Focus Fund, which rose more than 18% annually and outpaced its closest rival by more than three percentage points.

Too bad investors weren’t around to enjoy much of those gains. The typical CGM Focus shareholder lost 11% annually in the 10 years ending Nov. 30, according to investment research firm Morningstar Inc.

These investor returns, also known as dollar-weighted returns, incorporate the effect of cash flowing in and out of the fund as shareholders buy and sell. Investor returns can be lower than mutual-fund total returns because shareholders often buy a fund after it has had a strong run and sell as it hits bottom.

At the close of a dismal decade for stocks, the CGM Focus results show how even strategies that work well don’t always pay off for investors. The fund, a highly concentrated portfolio typically holding fewer than 25 large-company stocks, offers “a really potent investment style, but it’s really hard for investors to use well,” says Christopher Davis, senior fund analyst at Morningstar.

The gap between CGM Focus’s 10-year investor returns and total returns is among the worst of any fund tracked by Morningstar. The fund’s hot-and-cold performance likely widened that gap. The fund surged 80% in 2007. Investors poured $2.6 billion into CGM Focus the following year, only to see the fund sink 48%. Investors then yanked more than $750 million from the fund in the first eleven months of 2009, though it is up about 11% for the year through Tuesday.

“A huge amount of money came in right when the performance of the fund was at a peak,” says Mr. Heebner, the fund’s manager since its 1997 launch. “I don’t know what to say about that. We don’t have any control over what investors do.”

Delivering an 18% return from 2000-2009, a horrible period for the stock market, is no mean feat. Unfortunately, the trade-off required to achieve to such an impressive return is variable or “lumpy” short-term performance.

Instead of earning 18% on their money over the decade, the average investor earned -11%! This is what happens when investors make decisions based on past performance – they buy high and sell low.

In my post, I’ve repeatedly written about the importance of temperament. The article above demonstrates why it’s so important. Beating the market, like success in any field, is a long-term endeavor that requires patience and discipline. Unfortunately very few investors are able to consistently control their behaviour.

I will wrap up this post with a quote from Buffett’s 1996 letter to Berkshire Hathaway shareholders.

Most investors, both institutional and individual, will find that the best way to own common stocks is through an index fund that charges minimal fees. Those following this path are sure to beat the net results (after fees and expenses) delivered by the great majority of investment professionals.

Should you choose, however, to construct your own portfolio, there are a few thoughts worth remembering. Intelligent investing is not complex, though that is far from saying that it is easy. What an investor needs is the ability to correctly evaluate selected businesses. Note that word “selected”: You don’t have to be an expert on every company, or even many. You only have to be able to evaluate companies within your circle of competence. The size of that circle is not very important; knowing its boundaries, however, is vital…

… Your goal as an investor should simply be to purchase, at a rational price, a part interest in an easily-understandable business whose earnings are virtually certain to be materially higher five, ten and twenty years from now. Over time, you will find only a few companies that meet these standards – so when you see one that qualifies, you should buy a meaningful amount of stock. You must also resist the temptation to stray from your guidelines: If you aren’t willing to own a stock for ten years, don’t even think about owning it for ten minutes. Put together a portfolio of companies whose aggregate earnings march upward over the years, and so also will the portfolio’s market value.

In my next opinion post I’ll attempt to answer the following question: Is there any way that we can stack the odds in our favour when selecting a fund manager, investment strategy or stocks for our portfolios?

In the meantime, please join the debate by commenting!


P.S. This post has focused on performance relative to a market benchmark or index. This is different from absolute performance, that is whether or not an investment makes or loses money.

Absolute volatility, or the variability in the overall performance of an investment portfolio, does matter. It matters because a higher-level of volatility equals a wider range of potential outcomes, both good and bad.

The degree to which volatility matters depends on each investor’s objectives. For example, it matters less if an investor is:

  • Trying to maximize future wealth.
  • Has a long-term investment horizon.
  • Able to stop themselves from acting foolishly.

On the other hand, volatility matters more if an investor is:

  • Counting on an investment to provide income that they need.
  • Has a short-to-medium-term investment horizon.
  • Overly concerned by volatility.

It’s also worth noting that higher volatility isn’t always rewarded with higher returns – in many cases it isn’t. Academics call this the low volatility anomaly. Ironically, investments with a low absolute volatility can often appear “risky” (from a relative performance standpoint) when compared to most market benchmarks, as their performance will often diverge from that of most market-capitalization benchmarks.


* The investment strategy in Greenblatt’s book. The screen combines 2 factors; a measure of business quality (Return on capital = EBIT/(Net Working Capital + Net Fixed Assets)) and valuation (EBIT/Enterprise Value).

** This is a tautology. Judging by the way they invest, it seems that many investors forget the logic of this obvious statement.

*** The Brandes Institute has performed a similar studies on the performance of mutual funds around the world. They concluded that.

Over the years, Institute research has shown that active managers, even the best-performing ones, suffered periods of weak returns relative to benchmarks and their peers. But underperformance, up to three years, had relatively little impact on the best-performing fund’s ability to deliver success over 15 years.

Death, Taxes and Short-Term Underperformance: International Funds

Death, Taxes and Short-Term Underperformance: Emerging Market Funds

Death, Taxes and Short-Term Underperformance: Global Equity Funds



    • @CapitalMarketsGuy. Thanks for the comment. Unfortunately benchmarking creates all sorts of unintended consequences and perverse incentives.

      In many cases benchmarking is a feeble and misguided attempt at managing uncertainty. Investing is all about the future and the future is uncertain and unknowable. This is a fact that I repeat often on my blog because it’s fundamental to investing.

      Unfortunately, uncertainty about the future makes a lot of people very uncomfortable. So the idea of a readily observable, “objective” (I use the word very loosely) standard against which to compare investment strategies is appealing, especially in group decision-making or in situations where performance may be scrutinized.

      In reality, there is nothing independent or objective about any benchmark. All market capitalization-weighted benchmarks are based on assumptions and all benchmarks contain embedded risks. There is ample academic evidence demonstrating this.

      A benchmark is simply a portfolio constructed using a set of rules and assumptions. Any comparison is meaningless unless you understand the potential implications of these rules and assumptions. If you don’t, then how can you assess the suitability of a benchmark, let alone use it to assess the performance or risk of an investment strategy?


  1. Here’s an interesting article from Research Affiliates showing how even the very best long-term performers spend a considerable amount of the time under-performing the market over the short-to-medium term.


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