Seven Rules for Beating the Market
Thursday, August 28, 2014

Last week, I discussed how beating the market is hard to do. I wrote the commentary to provoke an awareness of the challenge that faces anyone pursuing an active strategy. Bluntly put, if you try to handpick investments without a disciplined, rational, well-thought-out plan for doing so, (barring really good luck) you will underperform.

A task that is hard is not one that is impossible. Individual investors can do better than the S&P 500. Today, I’m going to give guidance on how. It will be guidance that applies to a wide variety of specific approaches, including value, growth and technical analysis. I’m going to intentionally keep the guidance broad for an important reason: Regardless of the investing style you like to follow, the overarching rules for success don’t change.

Rule 1: The optimal strategy is not one that maximizes return, but rather one that helps you stick to your long-term investing plan and achieve your goals. Big returns always sound enticing. Pitched by someone with a charismatic personality, a high-return strategy sounds even better. But if you can’t stick to the strategy because of its complexity, the volatility it incurs, the time commitment it requires, the number of transactions associated with it, your interest level or any other reason, then it’s not an optimal strategy for you. If you are unwilling to or can’t stick with a strategy, don’t use it.

Rule 2: Set up procedures to keep your emotions in check. The biggest threat to most people’s portfolios is not the economy, the Federal Reserve, valuations, or high-frequency traders, it’s their brain. The human mind evolved to cope with very different hazards than Mr. Market’s ever-changing moods. So be cognizant of what your emotional tendencies are and set up procedures to keep them in check. These can include pre-written sell rules, limiting how often you check your portfolio, triggers to periodically adjust your portfolio or consulting with a financial adviser.

Rule 3: Think and invest different. Your biggest advantage as an individual investor is that you are not tied to an investment objective. Rather, you are allowed to invest in anything your wealth, your financial goals and the tax code allow you to. So why focus on the 300 largest U.S. stocks when there are nearly 5,000 listed on the U.S. exchanges and a large choice of funds that invest in international securities? Better yet, why use the same strategy everyone else is or focus on the stocks currently making headlines? If you want to beat the market, you have to invest in a different manner than most people.

Rule 4: Use the wisdom of the crowds to your advantage. While market efficiency is a big hurdle for active strategies to overcome, there are benefits to be gained from paying attention to the collective thoughts of market participants. We (AAII) use relative valuation rules for managing our portfolios, letting the market help guide our views about what is cheap and what isn’t. The trend in earnings estimate revisions can tell you if a company’s outlook is brightening or worsening. Momentum indicators such as the 26-week relative price strength rank pair well with low-valuation strategies.

Rule 5: Higher Valuations = Greater Expectations = More Room for Disappointment. The more favorably people view a company, the smaller its margin for error. Far more money is made from buying stocks that are undervalued than from buying stocks that are overvalued. Even if you are a growth investor, make sure the stock is undervalued relative to its prospects (after ensuring those prospects don’t assume an overly optimistic outlook).

Rule 6: Lower your costs. Every dollar you pay in investment expenses and transaction costs is a dollar you will never see again. In addition to trading with less frequency, take advantage of the tax law. Put your most tax-efficient investments in your traditional brokerage accounts, and use your tax-sheltered accounts (e.g., IRAs) for your least tax-efficient investments and strategies. Your goal should be to maximize the benefit from what you spend.

Rule 7: Develop a consistent, well-defined approach to investing and stick to it regardless of what the market is doing. Being a successful active investor requires having a plan based on factors and strategies proven to work over the long term.

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The Week Ahead

The U.S. financial markets will be closed on Monday, as will our offices, in observance of Labor Day.

Only three members of the S&P 500 index will report earnings next week: H & R Block (HRB) and PVH Corp. (PVH) on Wednesday and Joy Global (JOY) on Thursday.

The week’s first economic reports will be the August ISM manufacturing survey, July construction spending and the August PMI manufacturing index, all of which will be released on Tuesday. Wednesday will feature the August ADP Employment Report, July factory orders and the periodic Beige Book. The August ISM non-manufacturing index, July international trade and revised second-quarter productivity will be released on Thursday. Friday will feature August jobs data, including the change in nonfarm payrolls and the unemployment rate.

Several Federal Reserve officials will make public appearances late in the week. Governor Jerome Powell, Cleveland president Loretta Mester and Minneapolis president Narayana Kocherlakota will speak on Thursday. Philadelphia president Charles Plosser and Boston president Eric Rosengren will speak on Friday.

Although October has a worse reputation, September ranks as the worst-performing month of the year for the Dow Jones industrial average, the S&P 500, the NASDAQ and the Russell 1,000. It is also the 10th worst for the Russell 2000. Average declines are 1% or less during both midterm and non-midterm Septembers. Notably, the S&P 500 has risen during approximately 45% of all Septembers since 1950, so while market weakness next month would not be unusual, it is in no way certain to occur.

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AAII Sentiment Survey

Bullish sentiment topped 50% for the first time since December 26, 2013, in the latest AAII Sentiment Survey. Bearish sentiment, meanwhile, continued to drop, falling below 20% for the first time this year.

Bullish sentiment, expectations that stock prices will rise over the next six months, rose 5.8 percentage points to 51.9%. This is only the fourth time optimism has exceeded 50% since February 2011. It is also the first time bullish sentiment has exceeded its historical average of 39.0% for three consecutive weeks or more since March 2014.

Neutral sentiment, expectations that stock prices will stay essentially unchanged over the next six months, declined 1.4 percentage points to 28.8%. This is the lowest neutral sentiment has been since January 2, 2014.

Bearish sentiment, expectations that stock prices will fall over the next six months, dropped by 4.4 points to 19.2%. Pessimism was last lower on December 26, 2013 (18.5%). The drop keeps bearish sentiment below its historical average of 30.5% for the 39th time in the past 46 weeks.

At current levels, optimism is unusually high and pessimism is unusually low (more than one standard deviation away from their respective historical averages). Since our survey began in 1987, the S&P 500 has typically experienced weaker than normal returns whenever bullish sentiment is unusually high or bearish sentiment is unusually low. The median six-month returns for the large-cap index have been 3.8% following unusually high optimism and 4.5% following unusually low pessimism. The median six-month return over the survey’s entire history is 5.2%.

Bullish sentiment has risen by a cumulative 21.0 percentage points over the past two weeks, while bearish sentiment has dropped by a cumulative 19.0 percentage points. The reversal comes as the S&P 500 rebounded off of its short-term lows and broke above 2,000. This rebound has also alleviated fears among some individual investors about a possible correction having started earlier this month. 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.

This week’s special question asked AAII members how, if at all, the current bull market is impacting their attitude toward U.S. stocks. Answers were varied. About 36% of respondents said the current length of the bull market is having no impact. Some of these respondents said they were more focused on valuation measures, some are more focused on Federal Reserve policy and others simply said they are focused on the long term. About 18% of respondents indicated they are more optimistic because of the bull market’s resiliency, while 12% said they are more pessimistic because of it.

Here is a sampling of the responses:

  • “Not much, because I invest for the long term.”
  • “I am more optimistic that the market has more upside before hitting a correction.”
  • “I’m cautiously optimistic, but will be paying close attention to the Federal Reserve and interest rates.”
  • “I’m definitely more cautious; waiting on pullbacks and analyzing stocks more thoroughly.”
  • “It’s harder to pick undervalued stocks.”
  • “I think we’re due for a correction, but the long-term outlook still seems positive.”
  • “It’s making retirement a lot easier.”


This week’s Sentiment Survey results:

Bullish: 51.9%, up 5.8 points
Neutral: 28.8%, down 1.4 points
Bearish: 19.2%, down 4.4 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!