If 1,000 Investors Invest, One Should Randomly “Beat the Market” Ten Years in a Row

But what about stories of investors like Peter Lynch who managed to beat the market fourteen years in a row while managing the Magellan Fund? Isn’t he proof that someone can beat the market consistently?

Not to downplay Lynch’s skills, but a big part of that is sheer luck. Someone has to “win” and it happened to be Lynch.

Let’s assume, just for a moment, that everyone managing a mutual fund is very, very skilled – effectively equal in skill. Some might be a little more skilled than others, but these people are mostly so sharp that they balance each other out.

Given that they’re all so skilled, they’re all going to be effectively driving the market together. If all of the people investing in the stock market are very, very skilled, the stock market is going to essentially match what these guys and gals do as a collective whole.

However, not all of them own the same investments. Some invest in Company A while others invest in Company B and so on. Each investor has their own individual portfolio that’s nothing like the investments of the others.

This would mean that, in a given year, half of the fund managers would beat the market and half of them would not (it’s essentially impossible to perfectly match the market). Some of them will have made good guesses about what happens in a particular year, while some do not.

No one can predict the future. No matter how good you are, unforeseen events are going to sometimes benefit a company and sometimes damage it, and that’s going to affect the value of a stock investment in that company.

So, in a particular year, some set of companies will do better than the market and some set of companies will do worse. Because of that, some of the investors will randomly own more stocks in the good companies and beat the market, while others will randomly own more stocks in the bad companies and fail to beat the market that year.

The next year, who knows? The whole game starts over again. The next year will bring a different set of winners and losers, as everyone changes around their portfolios and different companies have different unexpected events.

So, let’s say we have 1,000 investors. During year one, half of them will beat the market. That leaves 500 winners. During year two, half of those guys and gals will beat the market again, meaning you’ll have 250 people who beat the market in years one and two. After year three, 125 people beat the market all three years. The next year, 63 people beat the market all four years. The next year, 32 people beat the market all five years. After that, 16 people, then 8, then 4, then 2, then just one person beats the market over ten straight years.

That one person still left standing, the one person who beat the market ten years in a row, is going to look like a genius and money and opportunities are going to flock to that fellow. However, as smart as that person is, part of his or her success is just that he or she was able to be the one frog that safely hopped across the interstate without getting hit by a big unexpected event.

Yes, there are some differences in the skills of fund managers, but when you recognize that pretty much everyone running the funds are incredibly skilled and that the market is littered with nonstop random events and that no one can predict the future, you end up with fairly random winners and losers.

— Nikki Earley