FS Archive Editorials

The “Beat the Market” Fallacy

by Robert Prechter, President, Elliott Wave International | July 17, 2009

During long bull markets, a myth develops that a money manager’s goal is to match or beat some benchmark for a market that is rising. This judgment bias explains why investors in recent years came to believe that a proper benchmark against which to judge money managers was the gain or loss recorded by the S&P index. Although “beating the S&P” became a popular basis upon which to judge performance, it is bogus.

The fallacy of this belief is nakedly exposed in a big bear market. Even money managers who succeed at their stated goal of beating the S&P can ruin your retirement. In the real world, customers are (surprise!) devastated if they lose half their invested capital, even if the S&P falls even more than that amount, say, 58 percent. How can this be, if the sensible, proper goal is to beat the S&P? Well, that is not a sensible, proper goal.

The goals of investing should be (1) to keep money and (2) to make money. Money managers who successfully protect your capital and make money for you in changing environments are truly serving you. Those whose goal is to beat the S&P will eventually serve you up.

The beat-the-market fallacy is even more obvious when one takes into account the fact that markets are bi-directional. If a money manager is supposed to beat the market on the upside, shouldn’t he also have to beat it inversely (with short sales) on the downside? If the S&P falls 58 percent, shouldn’t that performance be the benchmark, so that anyone who makes less than 58 percent is a piker, while the only good managers are those whose short sales made more than that?

Tell me: Why does this proposal sound absurd simply because market direction changed? In a currency ratio, direction is quite obviously irrelevant.

Euro/yen goes in the opposite direction of yen/euro, yet both ratios express precisely the same relationship. According to the beat-the-market benchmark, as the market fluctuates, the manager in Europe is supposed to beat the ratio in one direction, while a manager in Japan is supposed to beat the ratio in the other direction! Likewise, the S&P expresses the S&P/dollar ratio, of which the dollar/S&P ratio is simply the inverse and of no theoretically different consequence.

It does no good to say that the reason for such a benchmark is that the stock market usually goes up, because this statement describes only the past, not the future. Had you made this judgment in England in 1720, it would have done you no good for 64 years. Had you made it in Rome in 300 A.D., it would have done you no good ever.

The ridiculousness of the beat-the-market fallacy is further revealed by observing that the market is a fractal. It fluctuates at all degrees of trend. So which degree of trend is one supposed to beat? If the market rallies for three weeks and falls for two, is the only good manager someone who beats the return on the rally and then beats it on the decline? What about a 3-day rally and decline? What about 3 hours?

Anyone trying to reason himself out of this conceptual dilemma is forced to fall back on arbitrariness. Maybe moves of only a certain duration count; say, one year. Does this mean the manager is forgiven if he fails to catch, much less beat, the 1987 crash, in which the S&P lost 37 percent of its value in two months, but he will be judged negatively if he fails to beat the S&P when it retreats 20 percent over the course of two years? Forget it; no such quantitative filters can make this flawed theory work.

Your first goal should be to hold onto your money. Your second goal, the goal of investing, is to take on risk when the odds are way in your favor, so you have a good chance of making money.

For more information, download Robert Prechter’s free Independent Investor eBook. The 118-page resource teaches investors to think independently by challenging conventional financial market assumptions.

Bio: Robert Prechter has written 13 books on finance, beginning with Elliott Wave Principle in 1978, which predicted a 1920s-style stock market boom. His 2002 title, Conquer the Crash, predicted the current crisis. Prechter’s latest interest is a new approach to social science, which he outlined in Socionomics—the Science of History and Social Prediction published in 2003. In July 2007, The Journal of Behavioral Finance published “The Financial/Economic Dichotomy: A Socionomic Perspective,” a paper by Prechter and his colleague, Dr. Wayne Parker. Prechter has made presentations on his socionomic theory to the London School of Economics, Georgia Tech, MIT, SUNY and academic conferences.

Contact Information

Elliott Wave International
P.O. Box 1618
Gainesville, GA 30503
800-336-1618 Toll Free
770-536-0309 Phone
770-536-2514 Fax
Email