Trying To Beat The Market Is A Fool’s Errand

Proponents of indexing as the best investment strategy seem to take great delight in reporting how the vast majority of professionally managed portfolios (mutual funds, separately managed accounts, hedge funds, ETFs, etc.) fail to outperform the S&P 500.  Therefore, they argue, it is best not to even try. Investors should simply invest in index funds and forget about it.

At first glance, this would appear logical because in truth their statistics are true and valid.  On a total return basis, the vast majority of investor funds that are professionally managed do underperform the S&P 500 on a total return basis. However, there is a significant flaw with this line of reasoning.

Prominent Reasons Why Active Management Often Fails to Outperform

There are a few extenuating reasons why many actively managed accounts might underperform.  For brevity’s sake, I am not going to try to list all the extenuating circumstances. A comprehensive discussion would be too extensive, and not my true focus.

Some of the most prominent reasons for failure to outperform are management fees and costs, over-diversification, restrictions imposed by investment policy statements, and perhaps the biggest factor--becoming victims of their own success. The first couple of reasons are self-explanatory.

Suppose a small and newly created mutual fund had an extraordinary track record over its first few years of existence. This extraordinary record could have been a function of its small size and perhaps an attractive market environment with low stock valuations. 

The new fund will often attract significant amounts of new money. Its greatest inflows may come when the market environment has become unfavorable, when valuations are no longer favorable. However, the fund must invest it. 

In contrast, if a mutual fund produces a poor track record over a certain period, it will often suffer extensive liquidations. These liquidations may occur precisely when better judgment would suggest buying stocks instead of selling them.  The fund will be forced to sell undervalued stocks.  

Active managers face numerous extenuating circumstances that market indexes are spared.

I am not attempting to justify underperformance. Instead, I am simply attempting to illustrate a few reasons why it may happen. 

Should investors even concern themselves with trying to outperform the general market on a total return basis?

My answer is emphatically no.

Basing Portfolio Design on Need

Rather than worrying about beating the market, I believe portfolios should be designed based on an individual investor’s specific goals, objectives and risk tolerances.

The S&P 500 index fund may be a completely inappropriate investment choice for certain investors. Here's a 20-year earnings and price correlated F.A.S.T. Graphs™ of the S&P 500 index with performance to establish a benchmark.

The most important metric I want to establish is the S&P 500’s current dividend yield of 1.8% (red circle).  

For those sticklers for detail, I also include the following graph plotting the historical year-end P/E ratio of the S&P 500 over this 20 calendar year timeframe.  Note that the beginning P/E ratio of the S&P 500 was 17.6.  This would indicate that it was in fact modestly overvalued based on my fair value calculation of a P/E of 15.  In other words, the S&P 500 was, based on my standards, moderately overvalued at the beginning of 1994, but only modestly so.  In other words, the S&P 500 was not overvalued enough to invalidate my thesis.

The following 20 calendar year performance over this timeframe is presented below (Note: The precise dates of this performance measurement are from December 31, 1993 to the S&P 500’s close on October 16, 2013).  Furthermore, the following performance report separates total return into its two components.  The capital appreciation component of 6.7% per annum correlates closely to the 7.1% earnings growth rate, adjusted for the modest premium valuation mentioned above.

But the most important metric, and the second component of total return, that I would like the reader to focus on is the dividend income stream that the S&P 500 produced.  Not only will this represent an income benchmark, it also simultaneously illustrates why I contend that the S&P 500 may not be an appropriate choice for certain types of investors.  (Clue, the S&P 500 with a current yield of only 1.8% would not cover the income needs of retired clients in need of a minimum income provided from a yield of 3% or better).

However, not providing enough current yield may not be the only reason that an S&P 500 index fund may be inappropriate for retirees in need of income.  There are also the issues of inappropriate levels of risk, as well as several specific constituents in the S&P 500 that retirees should never own.  In other words, it doesn’t matter that they are hidden within the construct of an index of 500 companies; they are simply inappropriate stocks that retirees should avoid.

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I am long KO, CLX, PEP and ED at the time of writing.

The opinions in this document are for informational and educational purposes only and should not be construed as a recommendation to buy or ...

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