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Beat The Market


April 15, 2023

Another article from the WSJ:

Investing is one of the few areas of life in which amateurs can—and should—outperform professionals.

The individual investors who have spent the past few years trying to beat the pros at their own game by chasing hot stocks have it all wrong. Instead, you should play a different game entirely.

Consider a new study that looked at the returns of more than 7,800 U.S. stock mutual funds from 1991 through 2020. It measured their returns against those of a market-matching S&P 500 exchange-traded fund and the total U.S. stock market. The comparisons covered monthly, annual and 10-year periods, as well as each fund’s longest track record, within those three decades.

On average, only 46% of funds outperformed the total market over monthly horizons; 39% beat the market over 12-month periods; 34% over decadelong horizons; and a mere 24% for their full history.

Fees are part of the problem, of course. The typical fund charged a bit more than 1% in annual expenses over the period, according to the study’s authors, finance professors Hendrik Bessembinder of Arizona State University, Michael Cooper of the University of Utah and Feng Zhang of Southern Methodist University.

The typical fund returned an average of 7.7% annually over the three decades, after fees. Fund investors, however, earned only 6.9% annually because of their chronic compulsion to chase hot performance and flee when it goes cold.

Such buy-high-and-sell-low behavior tends to flood fund managers with cash at times when stocks have already risen in price—and to force the funds to sell stocks after a decline. The managers can perform only as well as their worst investors allow them to.

That cost of “being human,” as Prof. Bessembinder puts it, is almost as high as the drag from annual fees.

Overall, the study finds, investors sacrificed $1.02 trillion in wealth by investing in funds mostly run by stock pickers instead of buying and holding a market-tracking S&P 500 index fund.

I think another factor is at work here, too. Total-market index funds consist of about 4,000 stocks, but fund managers have to be choosier than that to justify their fees. On average, actively managed U.S. funds hold 160 stocks, according to Morningstar.

In the long run, however, nearly all the market’s return comes from a remarkably small number of stocks—giant winners that rise in value by 10,000% or more over the course of decades. Investor and financial historian William Bernstein of Efficient Frontier Advisors in Eastford, Conn., calls such companies “superstocks.”

Earlier research by Prof. Bessembinder shows that less than half of all stocks even generate positive returns over their publicly traded lifetimes, and that only 4.3% of stocks created all the net gains in the U.S. market between 1926 and 2016. [This finding is consistent with the idea of the Black Sean.]

That means searching for the next superstocks is like hunting for a few needles in an immense field of haystacks. And professional investors, by design, can’t search the whole field and all the haystacks.

Unsurprisingly, other studies have shown that, on average, the fewer stocks a fund owns, the lower its returns.

Over the three, five, 10, 15, 20 and 25-year periods ended March 31, U.S. stock mutual funds holding at least 100 positions outperformed those with fewer than 50, according to Morningstar. Over all the same periods, except the past five years, the most diversified funds also earned higher returns than those with 50 to 99 holdings.

If, for instance, you’d invested $10,000 on April 1, 1998, in funds holding at least 100 stocks, you’d have earned an average of 7.4% annually through this March 31. That compares with 7.0%, on average, in funds with between 50 and 99 holdings and 6.5% in those that held fewer than 50 stocks.

The effect is stronger among ETFs, where those with fewer holdings tend to be even more concentrated in a single industry or a narrow slice of the market.

If fund managers could stick to only their best ideas, they might do better. But owning just a handful of stocks could create tax and regulatory headaches—and would expose the managers to massive withdrawals (and loss of fees) if returns faltered.

So most portfolio managers own too many stocks to focus on their best ideas—but not enough to maximize the odds of finding a giant winner.

Individual investors, by contrast, can capture every needle in all the haystacks with a total-market index fund. Then you can add the potential for outperformance by trying to pick the next superstocks yourself.

Unfortunately, many individual investors diversify by adding big, household-name companies too similar to what they already own, or by following the crowd into whatever’s red-hot.

Instead, search for superstocks among smaller, unfamiliar firms that have a proven ability to raise prices without losing business.

Limit yourself to a handful of possibilities, don’t put more than a total of 5% of your money in them and never add new money even if they go up. That way you can make a lot if you land a big winner, but you can’t lose much on the losers.

If you do find what you think is a likely superstock, you—unlike a professional—can hold for as long as it takes to reap a giant gain.

The word “professional” comes from the Latin for “declare publicly.” Professional investors no longer have insurmountable advantages over individual investors. They only profess that they do.

In the long run, you can’t beat the pros by trading faster or by joining a meme-stock mob. The way to outperform isn’t by blending into the herd, but by standing apart from it.

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