Investors want to know where stocks are going, and how quickly they’ll get there — why wouldn’t they? That’s the golden ticket. The road to El Dorado.
Investing, Schrödinger’s cat and the wave function that describes the state of quantum particles are all governed by probabilities of outcomes. Accepting this simple truth is liberating and will allow you to improve your odds of success systematically. Here, I provide a guideline of how investors can attempt to put probabilities in their favor.
Beating the market is no simple task. There are plenty of statistics that illustrate the difficulty of security selection. For example, according to the current SPIVA (S&P Indices Versus Active) scorecard, 82% of active large-cap fund managers underperformed the S&P 500 over a five-year period through the end of 2018. (Full disclosure: Author’s company occasionally uses S&P funds and data in its work with clients.) Sadly, the numbers are even worse over more extended periods or in more illiquid asset classes, where one would expect active managers to have a more significant advantage. With only 2 out of 10 investors beating the benchmark, the odds are often not in an investor’s favor.
Even more problematic — there is no predictive power in past outperformers. Managers that outperformed over one period tend not to do the same in subsequent periods. This means it’s not good enough to merely go on Morningstar and rank funds by past performance or their star rating. In their paper “Luck Versus Skill in the Cross Section of Mutual Fund Returns,” economists Eugene Fama and Kenneth French further illustrate that in aggregate, active management doesn’t outperform more than one would expect by sheer luck. Adding back the high fees and expense of active management skews the bell curve to the left, leaving most investors with a basket of underperforming managers.
Even Peter Lynch, arguably one of the greatest investors of all time, once wrote, “All the time and effort people devote to picking the right fund, the hot hand, the great manager, have, in most cases, led to no advantage.” Unfortunately, behavioral biases take over in the face of this information. Investors often tell themselves that they are better and smarter than the rest and that these statistics surely don’t apply to them. However, the data says otherwise.
At the basis of all active management is a prediction or opinion regarding future events. With thousands of analysts and traders pouring over company data, the price of the stock today quickly reflects all available public information. Since overall market returns tend to be driven in short spurts and by a small subset of stocks, your odds of losing are compounded by active security selection and market timing. From 1990-2017 the S&P 500 annualized return was 9.81%, according to Dimensional Fund Advisors, S&P data provided by Standard & Poor’s Index Services Group. (Full disclosure: Author previously worked for Dimensional Fund Advisors, where Fama and French serve on the board.) If you happened just to miss the best 15 days, your return dropped to 6.18%. So, in over 10,000 days, missing the best 15 reduced your growth of $1,000 from $13,739 to $5,365. Even just missing the best five days reduced your investment to $9,114. Point being, stay seated, or you may miss it.
Now, for a second, forget about the data. Anecdotally, active management still doesn’t make sense in my opinion. If you have reliable information about future market performance, you also have minimal incentive to share with others. As more people act on this information, the more diluted your performance will be. So why share that knowledge for a 1% fee? Or give it away on TV, in a magazine or in monthly newsletter for $19.99? In economics, it’s the scarce resource that captures rents. So, investors would expect that an active manager would increase fees to offset any alpha being provided. Wouldn’t you? What makes this approach even more discouraging is that as fund assets grow, you start to see diminishing returns. As success attracts additional investors, a fund manager has to identify more great investment opportunities to net alpha for shareholders.
So, what’s the alternative? Simplicity is key. Consider holding an index, since in doing so, your odds are historically improved. That’s a good start. From there, you can further improve the likelihood of net returns by making a few minor adjustments. While index funds are certainly a positive evolution in investing, there are some inherent flaws in how they are designed and traded. The biggest issue being the drag on performance created by the reconstitution effect.
So-called factor-based investing is another way investors can improve returns over the broad market. Factor investing is an approach that builds portfolios based on quantifiable characteristics of securities that can explain differences in return. For example, small versus large companies is one factor that has historically illustrated a premium in return, with small companies generally outperforming large companies as an asset class. Value versus growth is another factor that explains differences in performance as value stocks as a whole have outperformed growth stocks. So tilting your portfolio to small-cap and value companies has historically improved returns over large-cap growth companies. I believe this makes sense in a free market economy where risk and return are related. For a deep dive into the data that supports this strategy, check out Fama’s and French’s “The Cross-Section of Expected Stock Returns.” Or for a simpler illustration, just consider the Ibbotson “Stocks, Bonds, Bills, and Inflation” chart.
Finally, pay attention to your tax strategy. Because it’s not what you earn; it’s what you keep — net of taxes.