April 2024, Newsletter
I have often talked about ways to beat the market, or at least get market-like returns, in my Newsletters. In contrast to this, there are many experts who will tell you that it’s near impossible to beat the market consistently. It’s no secret that beating the market is difficult and unfortunately this is particularly true for most small investors. But it doesn’t have to be that way, and in my opinion, it’s pretty easy to get market-like returns. And with a bit of strategy and luck, it’s possible to beat the market… maybe not every year, but definitely in the long run.
The Question
Why is it so hard to beat the market? The obvious answer is bad investor behaviour. There’s the emotional stuff that either scares people into selling low or makes people greedy and results in them buying too high. Then there are the brain issues like market biases, or beliefs of certain myths. Typical human behaviour is really bad for returns.
Another destroyer of returns is lack of diversification and portfolio planning. Small investors are notoriously just winging it when it comes to investing. They buy things like new AI stocks on a whim, without fully understanding their value or how they fit into their portfolio.
Let’s assume that all of you out there – my Newsletter followers – are immune to those bad behaviours. You each: construct objective and logical portfolios; and use all of the rules that I set out in a previous post. Will you beat the market? Not necessarily. But at the very least, you will achieve market-like returns and that is a very good start.
I have been fortunate enough to beat the market by an average of 1.5% over the last 11 years, however it wouldn’t have taken much to average a return lower than this, simply by making a big mistake in the early years. I also realize that luck can play a big part in returns. That said, even without luck on my side, I should continue to achieve at least market-like returns as I build portfolios that resemble the market and economy. I try to be like the market most of the time and deviate a bit when I think that I can squeeze more out of it.
Let’s Think About it Like a Game
You can think about investing like a game in which there are 2 players. Player 1 (small investor) can buy and sell anything they want, anytime they want, from anywhere on the planet. Player 2 manages a market ETF, such as the SP500 and owns all of the 500 biggest companies in the index.
It seems unfair that Player 1 (small investor) has total flexibility while Player 2 (ETF manager) is trapped within the confines of set rules and can rarely make changes to their portfolio of 500 companies. The constraints for Player 2 continue as the amount of each company they must hold depends on how big they are. So if Apple is worth 6% of the capital value of the SP500, he must own 6%. He must also hold companies that are what one may consider “loser companies” – the down and out, old school companies like steel or trains. Also, the smallest of the 500 companies become very small as a percentage of the total portfolio, I mean really tiny.
Player 2 also has limited access to international stocks, no small caps, no fixed income market, and no access to the thousands of ETFs that are available to the small investor. So which player would you rather be? It’s obvious, right? So why does the small investor advantage not play out in the real world of investing?
Consideration 1
Player 2 always has the big winners included in the 500. They also have a disproportionate amount of the big winners simply because of the rules of the index. Capital weighted indexes give more influence to big companies. Will Player 1, with only a few picks, have any of these winners? Only if they are lucky.
Consideration 2
Things get worse for Player 1. There’s something called market skew that makes winning harder. It means that returns across the index are not evenly shared among all stocks. Average market returns only work if you have all the stocks. If you don’t have all the stocks, then you must realize that the average return is generally comprised of a smaller number of companies with really big returns, while the rest (majority) under perform. Historically, about 1/4 of stocks over perform and 3/4 under perform. Picking stocks randomly will likely cause you to under perform. The odds are against you.
Consideration 3
With total flexibility, couldn’t Player 1 stock pick around the market Skew by picking the best companies? And would that not mean Player 1 would surely beat Player 2, as Player 2 must also hold bad companies? While Player 1 is at it, he could also bet against the bad companies (short sell) and achieve even higher returns. Its so simple! Win on both sides.
But it’s not that simple. This approach doesn’t work; it’s been tried and tested. So here is the problem: the world is a random place and no one can predict with certainty the future of even one company. If you buy really good companies (which is really difficult to define), they are often expensive, so if things go wrong in our random world, prices can crater fast. The advantage of a “really good” company washes out if you pay a normal to high price for it. I know what you are thinking, “Ok so let’s find stocks that are really good but cheap.”. Hmm, everyone is doing that already. Do you really have the skills to out think everyone?
The same thing happens with down and out companies; they can all of a sudden turn around, get bought out, or discover a new type of widget that drives their stock to the moon. It happens all the time. The point here is that stock picking is really hard. So it’s difficult to pick your way to success.
Being Different
To be fair, it’s easier to beat the market when Player 1 happens to be in the right stocks at the right time. Imagine that the SP500 index has stalled and small caps start to run up, or pick any other non SP500 group such as emerging markets or European stocks. Being different than the SP500 is good in these scenarios, but consider that the SP500 has been a big winner for the last decade, so being different could have meant years of under performance because you expected emerging markets to outperform and you were wrong.
A Word On Alternative Assets
Ok, I know many investors cannot live without their bonds, Tbills, GICs, Gold, Crypto, Silver, collectible Cabbage Patch dolls, real estate, etc. These have had their moments in time, but the reality is that in the very long run, they don’t achieve the same returns as holding stocks.
Unfortunately, this means that having any of these will, in the long run, lower your returns and the result is underperformance. There is an argument that some of these may enhance your risk/reward profile and that is ok if you feel that in a specific point in time its warranted (e.g.stocks are in a bubble), but the odds are generally against you over time, so you better be right in calling those, or at least be ok with lower returns.
Last Word
So why invest in individual stocks if it’s that difficult? Why not just get a Market ETF? To be honest, ETFs are likely the best answer for most people. If you manage your own portfolio, you must put in a lot of effort and be a little lucky to beat Grandma’s market ETF. But if you do, and your successful, those extra couple of percentage points can make a big difference over time and that is what this Newsletter is all about.
Portfolio Update
I am still behind the benchmark but I have caught up significantly from last month. Oddly, on an absolute dollar basis, I am outperforming the market because of currency gains. I always factor that out of my returns because I am measuring stock performance and not currency speculation. Nevertheless, these are real dollar gains that I could put towards buying expensive Dijon Ketchup.
Marc’s Monthly Moves
No moves this month.
Marc’s Portfolio YTD Performance
- Portfolio return: 8.2 % (including currency gains)
- Portfolio return: 5.0 % (without currency gains)
- S&P 500 return: 6.9 %
- RSP ETF S&P equal weight 2.9 %
- TSX: 4.8%
The portfolio is under performing the SP500 by 1.9 % points.
Money with Marc 