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Beating the Market: A Century of Failure

Active investment managers attempt to select superior securities or time markets to earn results that consistently outperform a static benchmark. You would think, based on the marketing messages from active managers, that they have been successful at delivering robust returns over the decades. This isn’t the case. In fact, active managers as a group have consistently underperformed their benchmarks for almost a century.

Alfred C. Cowles, III was the first person to quantify the results of active management in the early 1930s. Cowles meticulously measured the performance of professional stock forecasters and market timers over a period ending in June 1932. Shortly thereafter, he published his findings in an article titled “Can Stock Market Forecasters Forecast?” Cowles conclusion was simple and direct, “It is doubtful.”

Cowles divided active management into two strategies: security selection and market timing. He then attempted to measure the presence of each skill separately. Cowles outlines this process in the introduction to his paper:

This paper presents results of analysis of the forecasting efforts of 45 professional agencies which have attempted, either to select specific common stocks which should prove superior in investment merit to the general run of equities, or to predict the future movement of the stock market itself.

The paper falls into two main parts. The first deals with the attempts of two groups, 20 fire insurance companies and 16 financial services, to foretell which specific securities would prove most profitable. The second part deals with the efforts of 25 financial publications to foretell the future course of the stock market.


Using two separate sets of data from insurance company returns and securities analysts’ picks, Cowles found that only about 1 in 3 were able to select stocks that outperformed the general market over a period of about 5 years. In addition, he measured the securities analyst performance to be about 1.4 percent annually below the market, and the insurance companies performed by about 4.7 percent below the market. The insurance companies had real investment costs while the analysts’ results were only hypothetical. This may have accounted for the large difference in underperformance.

Cowles also noted that the winning analysts and insurance funds may have a tough time proving they had skill because their results were worse than a random distribution. In layman terms, this means a group of monkeys throwing darts at the stock tables would have performed at least as well.

Turning to market timing, Cowles tested the results of a strategy called Dow Theory, named after its founder, Charles Dow. The data gathered on Dow Theory actually followed the predictions of Dow’s predecessor, William Peter Hamilton. From 1904 until his death in 1929, Hamilton wrote editorials in the Wall Street Journal where he made market predictions.

Hamilton made 90 separate market timing calls over the 26 year period. His results were a random event; 45 calls were right and 45 were wrong. This is the same result expected from flipping a coin.

Hamilton earned a total return of 12.0 percent per year over the 26 year period while the Dow Jones Industrial Average earned 15.5 percent per year. Corrections were made for the effect of brokerage commissions, dividends, and interest while Hamilton’s funds were out of the market.

The Cowles Commission report failed to find any individual or organization with the ability to consistently select individual securities or foretell the market returns. Winning managers and analysts were consistent with chance rather than skill or insight, except for the worst forecasts, which appeared to be lower than expected by chance.

It is now 2011 and nothing has changed. The 1 in 3 success rate for active managers over a 5 year period was consistent throughout the 20th century and into this century. I calculated the same results for my recent book, The Power of Passive Investing using multiple data sources. In addition, the average active manager underperformed their benchmark by about 2 percent. This was close to the average underperformance that Cowles observed in the 1930s. Nothing has changed.

In summary, there are three consistencies to take away from active management:

  1. Few active managers consistently outperform their benchmarks.
  2. The winning managers do not outperform by much while the losing managers underperform by much more.
  3. Past winning managers generally do not persist into the future. Thus, most outperformance is a result of luck rather than skill.

Wise investors don’t rely on active management strategies to achieve their financial objectives, and there’s no reason to anymore. Instead, allocate your assets for the long-term based on your financial need, and select low-cost index funds and ETFs to capture the returns of asset classes you select. A passive asset allocation strategy using low-cost index funds that is regularly maintained has the highest probability for reaching your financial goals.

More about Alfred Cowles, III, and the Cowles Foundation

Alfred Cowles, III dedicated his life to elevate economics into a more precise science using mathematical and statistical techniques. He was a Yale University graduate and founder of the Cowles Commission in 1932. For ten years prior to founding the commission, Cowles maintained a private organization for statistical research on problems of investment and finance.

The Cowles Commission was established by Cowles in Colorado Springs, Colorado. It moved to Chicago in 1939 after forming an affiliation with the University of Chicago. During 1955, the professional research staff accepted appointments at Yale and, along with other members of the Yale Department of Economics, formed the newly established Cowles Foundation.

The Cowles Foundation seeks to foster the development and application of rigorous logical, mathematical, and statistical methods of analysis. The foundation boasts many prestigious researchers and directors, and over the decades, 23 have become Nobel Laureates.

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