Don’t Assume Beating the Market Is Easy
Thursday, August 21, 2014

The majority of investors use active strategies for a single reason: to beat the market. There are other reasons, of course, to handpick securities (or pay a fund manager to do so), such as realizing a higher stream of portfolio income or reducing volatility. Today, though, I want to focus on what you should consider when trying to beat the market.

The financial industry has done a great job making beating the market seem easy. Go to just about any financial media outlet (traditional or social) and you’ll find plenty of chatter claiming index funds are for suckers. What you often won’t find is a frank discussion about the long-term results actually realized by a large group of investors or fund managers.

There is a good reason for this: The numbers aren’t good. Consider the performance data published in our 2014 Guide to the Top Mutual Funds. Just 35% of funds with 10-year track records beat the S&P 500 index on a 10-year annualized basis. In other words, you had nearly a two-thirds chance of trailing the S&P 500 over the past 10 years if you bought an actively managed fund. The actual odds are worse because funds that folded over the last 10 years are excluded (“survivorship bias”) from the current guide and taxes are excluded from the return calculations.

The performance hurdle is not just limited to mutual funds. Barry Ritholtz, who writes The Big Picture Blog, says an active trader has to beat the S&P 500 by 25% annually to come out ahead. The large margin primarily reflects the impact of taxes. The active trader pays short-term taxes, and these costs add up. The long-term passive investor, conversely, pays little in taxes until he or she retires and makes withdrawals at a potentially lower tax rate.

For the sake of argument, let’s say Ritholtz’s assumptions are wrong. There is still another line of reasoning to consider, the aggregate skill of investors and analysts. Computers have made it easier and quicker to analyze investments. We now have better access to information (and more of it too) about securities and investment strategies than ever before. Charlie Ellis argues that this spread of knowledge has led to increased competition among active managers.

In the current issue of the Financial Analysts Journal, Ellis observed, “Because all have ready access to almost all the same information, the probabilities continue to rise that any mispricing—particularly for the 300 large-capitalization stocks that necessarily dominate major managers’ portfolios—will be quickly discovered and swiftly arbitraged away into insignificance. The unsurprising result of the global commoditization of insight and information and of all the competition: The increasing efficiency of modern stock markets makes it harder to match them and much harder to beat them—particularly after covering costs and fees.”

None of this is to say that beating the market is impossible. We (AAII) have done so for many years with our Model Shadow Stock and Stock Superstars Report portfolios. What you should take away from this, however, is the importance of having a well-thought-out and disciplined plan. Trying to choose stocks based on what is in the news or buying the funds with the best one-year performance is a recipe for failure. So is a helter-skelter approach where you abandon a strategy when it stops works working temporarily or when there is overall market or asset class weakness. You have to play the long-term odds about what has and has not worked, be quantitatively driven, do things differently and keep costs down if you want to beat the market.

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AAII Model Portfolio Update

There were no transactions in the Model Shadow Stock Portfolio or the Model Fund Portfolio last month.

The Model Shadow Stock Portfolio lost 4.0% in July, performing worse than the Vanguard S&P 500 Index fund (VGINX), which was down 1.4%, but better than the Vanguard Small Cap Index fund (NAESX), which lost 4.9%, and the DFA US Micro Cap Index fund (DFSCX), which was down 5.8%. For the year, the Model Shadow Stock Portfolio is down 4.7%, trailing the Vanguard Small Cap Index fund, which is up 1.1%, and the DFA US Micro Cap Index fund, which is down 4.5%. The Model Shadow Stock Portfolio has a compound annual return of 17.5% from its inception in 1993, while the Vanguard Total Stock Market Index fund (VTSMX) has gained 9.3% annually over the same period.

The Model Fund Portfolio declined 1.5% in July. In comparison, the Vanguard Total Stock Market Index fund (VTSMX) lost 2.0%. For the year, the Model Fund Portfolio is now up 5.9%, ahead of the Vanguard Total Stock Market Index fund, which has gained 4.8%. The Model Fund Portfolio has a compound annual return of 9.6% from inception in June of 2003, while the Vanguard Total Stock Market Index fund has gained 9.1% annually over the same time period.

The Week Ahead

Just a handful of S&P 500 members will report earnings next week. They are Analog Devices (ADI) and Best Buy (BBY) on Tuesday; Brown-Forman (BF.B) and Tiffany (TIF) on Wednesday; and Avago Technologies (AVGO), Dollar General (DG) and Pall Corp. (PLL) on Thursday.

The first economic report of note will be July new home sales, scheduled for release on Monday. Tuesday will feature July durable goods orders, the June S&P Case-Shiller home price index and the August Conference Board consumer sentiment survey. The first revision to second-quarter GDP and the July pending home sale index will be released on Thursday. Friday will feature July personal income and spending, the August Chicago purchasing managers index and the University of Michigan’s final August consumer sentiment survey.

The Treasury Department will auction $29 billion of two-year notes on Tuesday, $35 billion of five-year notes and $13 billion of floating two-year notes on Wednesday, and $29 billion of seven-year notes on Thursday.

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AAII Sentiment Survey

Optimism about the short-term direction of stock prices jumped to a nine-month high in the latest AAII Sentiment Survey. Neutral sentiment, meanwhile, dipped below its historical average for the first time since early January.

Bullish sentiment, expectations that stock prices will rise over the next six months, rose 6.3 percentage points to 46.1%. This is the largest amount of optimism recorded by our survey since December 26, 2013 (55.1%). It is also just the second time since March with a bullish sentiment reading above its historical average of 39.0% on back-to-back weeks.

Neutral sentiment, expectations that stock prices will stay essentially unchanged over the next six months, fell 3.0 percentage points to 30.2%. The drop ends a 32-week stretch of neutral sentiment readings above the historical average of 30.5%. It was the third-longest such streak in the survey’s history.

Bearish sentiment, expectations that stock prices will fall over the next six months, fell 3.3 points to 23.7%. Pessimism is now at a seven-week low. Bearish sentiment is also below its historical average of 30.5% for the 38th time in the past 45 weeks.

Bullish sentiment has risen by a cumulative 15.2 percentage points over the past two weeks, while bearish sentiment has dropped by a cumulative 14.5 percentage points. The reversal comes as the S&P 500 has rebounded off of its short-term lows and ended the survey period near record highs. This rebound has alleviated fears among some individual investors about a possible correction having started. Other factors contributing to the optimistic stance are second-quarter earnings, sustained economic growth and the Federal Reserve’s tapering of bond purchases. Keeping some individual investors pessimistic are prevailing valuations, the failure of the S&P 500 to set new highs, events in the Middle East and Ukraine, the pace of economic growth and Washington politics.

At current levels, both bullish and bearish sentiment remain within their typical historical ranges, as does the bull-bear spread. The bull-bear spread measures the difference between bullish and bearish sentiment.

This week’s special question asked AAII members if, and why, second-quarter earnings have impacted their six-month outlook toward stock prices. Slightly less than half of all respondents (49%) said the quarterly results haven’t impacted their outlook. Many of these members said either they are more focused on the economy or that quarterly earnings are too short-term of an indicator. Just under 23% of respondents said second-quarter earnings have positively influenced their outlook. Many of these respondents said earnings are improving. Earnings were viewed negatively or not good enough to justify current valuations by about 12% of respondents.

Here is a sampling of the responses:

  • “Earnings are not necessarily the real indicator of the underlying economy.”
  • “They are too short-term and thus unimportant in the long-term.”
  • “I believe the market is showing strength in varied sectors and the corporate profits are improving.”
  • “Earnings were good overall in the second quarter. The economy is slowly improving.”
  • “They’re still not high enough to justify the sky-high valuations.”

This week’s Sentiment Survey results:

Bullish: 46.1%, up 6.3 points
Neutral: 30.2%, down 3.0 points
Bearish: 23.7%, down 3.3 points

Historical averages:

Bullish: 39.0%
Neutral: 30.5%
Bearish: 30.5%
Take the Sentiment Survey.

Local Chapter Meetings
AAII Local Chapter Meetings offer you a variety of presentations from expert speakers who will give you their view on the world of investing. A bonus of attending a Chapter Meeting near you is the opportunity to meet other AAII members who share your interest and enthusiasm for investing. You can even share the Chapter experience with your family and friends by inviting them to attend Chapter Meetings with you!