Today I read an article by William Sharpe, titled “The Arithmetic of Active Management” [1]. It presents an intuitive concept that for some reason is frequently overlooked: The average invested dollar must equal the market return.

Then, after fees and commissions, the average invested dollar must underperform the market. That’s why the majority of mutual funds do worse than a random portfolio of stocks.

Tools such as derivatives and short-selling add overhead cost and also, on average, don’t beat the market. While you think you are hedging your investments by buying options contracts, another investor is thinking the same thing when he sells you those contracts.

So, unless you have compelling stock information that others don’t have, active trading will rarely help you beat the market. Mutual funds will rarely help you beat the market. Diversification, long-term investing, and choosing companies with strong fundamentals, are what beat the market.

The market has fallen over 50% since October 2007, so if you still have more than half your portfolio value from back then, Congratulations – you beat the market.

1. The Financial Analysts’ Journal Vol. 47, No. 1, January/February 1991. pp. 7-9

William Sharpe was awarded the 1990 Nobel Prize Laureate in Economics. I don’t think this is what he won it for, though.