In life very few of us set our sights on being just average, perhaps being of average weight is the exception. We generally strive to be above average, and when it comes to our investment portfolios we expect to earn above-average returns. Why should you pay someone to earn you returns that underperform those of your peers? In this posting, I’m going to tell you exactly how you can earn returns that will knock the socks off those of your golfing buddies. Now I know some of you are confused and thinking, “Andrew, your previous posts promoted a conservative, rational approach to investing, so how can I possibly expect to earn higher than average returns by being conservative?” Well, my dear reader, the proof is once again in the academic pudding, and I will reference an excellent essay and study that will teach you how to be an above- average investor.

 

Firstly, I don’t believe equity markets are 100% efficient. As I pointed out in a previous article, we humans often make investment decisions based on emotions rather than economic reality. Some advisors will tell you they can exploit these mistakes for you. My view is that somewhere right now, someone has dropped a $50 bill on the ground. This is inefficient behaviour, but does it mean we should all devote our time and resources to running around trying to find that bill? Probably not. In the same vein, I don’t think it’s worth the time or cost to try to identify and then profit from mistakes in the market. A huge number of hedge funds, mutual funds, and pension funds are competing to exploit these inefficiencies. A paradox exists in that by actively searching and then exploiting any market inefficiencies, these funds are making the markets more efficient. Regardless of how efficient/inefficient you think the markets are, competition has a cost and the gross returns of the equity market, minus these costs of financial intermediation, must equal the net returns actually earned by you, the investors. 

 

Now here’s where you’re going to get mad at me. To be above average, all you have to do is capture the returns the market offers as efficiently as possible. I know you thought I was going to offer you a sure-fire strategy to beat the market. What I’m actually offering here is a strategy to beat the average individual investor. Before you turn off your computer in disgust with me, you should note that this strategy can earn you up to 76% more profit than the average investor. That extra 76%, I hope you’ll agree, is worth examining more closely.

 

In 2005, John C. Bogle wrote a great essay titled “The Relentless Rules of Humble Arithmetic”[1] for the Financial Analysts Journal. For his essay, Mr. Bogle studied the returns of the U.S. market and returns of investors in it from 1983 to 2003. During this period the S&P 500 returned 13.0% and the average S&P 500 index fund earned 12.8%. The difference was attributed to the low fees charged by index funds and some tracking error, which relates to the index fund not being able to perfectly replicate the S&P 500 at every given moment. During the same period, the average mutual fund returned 10%. By now, hopefully I’ve hammered home the idea that fees eat into your returns, and a big factor attributable to the underperformance of mutual funds is just that – high fees. So the big question is: how did individual investors do during this period? To be frank, they did badly. Driven by their numerous behavioural faults, including a need to chase performance and trying to time the market, needs fuelled by the mutual fund industry, marketing material, and poor investment guidance, the average investor earned a 6.3% compound annual return, just 49% of what the index fund returned.

Simply buying and holding the index through an index fund would have earned a 12.8% return, yet the average investor’s desire to be above average actually achieved the opposite result. Even more important than the returns realized is the difference in profit each strategy yielded. Through the magic of compounding returns, investing $1 for 20 years at a 12.8% return yields a $10.12 profit. That same dollar invested at 6.3% only yields a profit of just $2.39. By actively chasing performance and trying to be above average, individual investors actually gave up $7.73 or 76% of their profit.

 

A few years ago an infomercial ran on TV for a little rotisserie oven. During the program, the host would put a roast or chicken into the oven, turn the dial and the audience would scream, “Just set it and forget it!” I recommend you do the same with your portfolio. Allocate a portion of your portfolio towards capturing market returns. Set your weightings, make the purchases, and then forget about them for the year. If necessary, at the end of the year, rebalance back to your original weightings. The key here is having the emotional discipline to stay the course and rebalance into poorly performing markets, especially if the market is turbulent and you’ve lost money. Keep focused on your long-term goals and not the day-to-day noise. Next time your buddy is bragging about that great stock he has just picked – up, jingle that $7.73 of extra profit your boring strategy has put in your pocket. Now I know some of you are probably still disappointed with this posting, because you wanted to know how to earn above-average market returns. Well, I can offer you some solace; in my next article I’ll cover some riskier asset classes, such as global real estate, emerging markets, small-cap stocks, value stocks, and so forth. These asset classes have higher risk profiles, so adding them to your portfolio should increase your portfolio’s overall expected return. Until then, have a great summer! 

[1] “The Relentless Rules of Humble Arithmetic,” Bogle John C, Financial Analysts Journal, November/December 2005.