Warren Buffett says that 99% of investors should not even try to beat the market.

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Is he right about that? Or is he overstating the case. How hard is it to actually beat the market?

In a recent Yahoo!Finance interview, Warren Buffett said that 99% of investors should not even attempt to beat the market. He said they would be much better off investing in a low-cost S&P 500 index fund. Is this good advice? My view is that his message is right, but he overstates his case.
Here are a couple of Buffett pearls of wisdom from the interview:

“Basically any attempts to pick the times to buy or sell, I think, are a mistake for 99% of the population. And I think that even attempts to pick individual securities is a mistake for people.”

“They don’t need to do anything but (invest in a low-cost S&P 500 index fund). Then they’ll get a decent result over time. To some extent, the smarter you try to be, the worse you do in investments. Now, there’s a few professional investors that will do better than the S&P over time. But the average individual isn’t going to be able to find them. And they don’t need them. That’s the beauty of it.”

Buffett’s real message to investors

What Mr. Buffett is really saying to investors is important: beating the market is very hard to do with any consistency. But it’s far from impossible. In his view, only 1% of investors have what it takes to pull it off. He bases this on the fact that most investors lack the time, commitment, knowledge, and discipline to succeed at active investing.

And he’s right about that. Even those investors who diligently study the market and do hours of research before making any decisions, are prone to some hard-wired human biases that are extremely difficult to overcome.

Some examples of these hard-wired biases are…
• Confirmation bias
• Myopic loss aversion
• The sunk cost fallacy
• The endowment effect
• Availability bias

Confirmation Bias
Confirmation bias occurs when investors seek out or evaluate information in a way that fits with their existing thinking and preconceptions. They do this to bolster existing attitudes and beliefs, rather than looking for flaws in their thinking that could cost them money.

Myopic Loss Aversion

Myopic loss aversion is a combination of two emotions. Loss aversion is a healthy emotion for an investor to have, because it acts like a safety valve that prevents the investor from riding a stock all the way down to zero. At some point, the investor reaches his “pain threshold” and bails out.
But the myopic part is not healthy. I’m not crazy about the choice of this particular adjective, because it can be a little obtuse. But it means that the investor is too focused on the decline in price, and therefore he can’t see the other factors involved in making a sound decision about whether or not to sell.

The Sunk Cost Fallacy

Investors commit the sunk cost fallacy when they continue a behavior as a result of previously invested time and money. In a sense, this is nearly the opposite of myopic loss aversion. Here, the investor continues to hold on (refuses to sell) a losing position because doing so would permanently lock in the loss of their invested resources. This form of stubbornness is often referred to as “get-even-it is.”

The Endowment Effect

This bias occurs when an investor overvalues a stock that he owns, regardless of its actual market value. It is evident when people become relatively reluctant to part with a stock they own, even if doing so will result in a tidy profit. People place a greater value on things once they have established ownership. The endowment effect is an illustration of the status quo bias.

Availability Bias

Availability is a mental bias whereby investors make judgments about the likelihood of an event based on how easily an example, instance, or case comes to mind. For example, investors may judge the quality of an investment based on information that was recently in the news, ignoring other relevant facts.

You can’t overcome a bias if you don’t recognize that you have it

Unfortunately, most investors are unaware of the fact that they have these types of biases, so they are destined to repeat the same mistakes over and over again. They struggle to stay focused on the long-term, and instead react to the short-term, unwittingly making very expensive mistakes.

Based on my own observations over a 30 year career designing strategies and portfolios for clients, I would put the percentage of potential market-beaters at 10%.

Think of it this way. If you were offered an opportunity to participate in a game of chance, where the chance of winning is only 10%, would you go for it? I think most of us would pass on an opportunity like that. But those odds are based on the entire population of investors, regardless of their knowledge, skill level, or temperament.

Learned competency – a bias-free approach to investing
Now let’s introduce some competency factors to the situation. Let’s say you happen to be a professional poker player with several bracelets and a 7-figure income from gambling wins. If you were offered a seat at a tournament, where you knew that 90% of the players were amateurs, and 10% were professionals, would you go for it? Darned right you would. Are you guaranteed to come out a winner? No. But your odds are pretty good.

This is the nature of the investment game. A small subgroup of highly skilled professionals (and amateurs who are on their way to becoming professionals), taking advantage of their superior skills to take money from the unskilled amateurs in a fair game of chance.

When we take these skill factors into consideration, the odds of success go up considerably. Let’s try to put all these numbers into an easy-to-understand framework.

A Thought Experiment

Suppose we take a random sample of 100 investors with different backgrounds, skill levels, market knowledge, and desire to learn how to beat the market. Right off the bat we can eliminate 50 of them who don’t have the time, or the interest to put forth the effort it would take to attempt to beat the market. These folks are happy to take whatever the market offers them by sticking with index funds.
Of the 50 who remain, roughly 30 have the desire to beat the market, but they lack the necessary knowledge, skills, and temperament to succeed.

Of the 20 who still remain, about 10 have the potential to beat the market, but their performance is inconsistent. They beat the market sometimes, but then they take a hit that wipes out most or all of what they had gained. This could be a result of poor discipline, lack of patience, biased thinking, jumping around from one strategy to the next, overconfidence, over-trading, or some combination of all of these.

That leaves just 10 investors out of 100 who have the willingness, ability, skill, knowledge, and temperament to beat the market with enough consistency to rightfully claim success.

Back to my original question

Is Buffett giving good advice when he says that 99% of investors should just buy a low cost S&P 500 index fund? My answer is no, and here’s why.

Mr. Buffett is earnestly trying to help his audience avoid doing stupid things with their life savings. His intentions are pure, in other words. But I think he deliberately overstates his case in order to emphasize how hard it is to beat the market.

What I think he’s really saying is that beating the market is so difficult that most investors would be better off by simply capturing the returns of the market. But “most” investors doesn’t mean 99% of investors. That’s hyperbole. 90% is probably closer to the proportion of investors who should stick to index investing.

About the Author

Former head of equity trading, Northern Trust Bank, Chicago. Teacher, trainer, mentor, market historian, and perpetual student of all things related to the stock market and excellence in investing.

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