Outperforming the S&P 500 is not Easy. Don’t Be Fooled Otherwise.

I was browsing MarketWatch and noticed this article titled “Beating the market is easy”.  It’s a catchy title and I like to beat the market so I clicked on the link.  The article outlines 10 ways you can beat the market.  The market, in this case is the S&P 500.   The author outlines a few different strategies:

  • Implementing leverage (strategy 1).
  • Substituting different indices (strategies 2-9).
  • Indexing & Reducing fees (strategy 10).

These are not ways to “beat the market”.  First of all, the S&P 500 is a global index made up of 500 of the greatest corporations in the entire world.  Keep in mind, there are millions of corporations in the world.  Wall Street has sold this phony story to everyone that you’re a sucker if you can’t outperform the 500 best corporations in the world.  That’s like telling your kid he’s a loser if he doesn’t grow up to be a better basketball player than everyone on the NBA all-start team.  That’s nonsense.  “The market” is an incredible group of companies.  Being able to pick the companies that will outperform these 500 companies (on a risk adjusted basis) is not easy to do.  And it’s not surprising that most money manager can’t do it.

Anyhow, strategy 1 is the equivalent of taking on more risk.  If you increase the leverage in your portfolio you’re likely to increase the risk in your portfolio.  Especially if you’re simply buying one index.  Leveraging the S&P 500 is not a way to produce superior risk adjusted returns.  Now, there are clever ways to implement leverage so that it generates higher risk adjusted returns (like some risk-parity approaches), but simply leveraging the S&P 500 is not one of them.  The author fails to correctly assess risk adjusted returns and makes an apples to oranges comparison as a result.

Strategies 2-9 are all apples to oranges comparisons.  If you buy the Russell 2,000 Index and then compare your returns to the S&P 500 you are not making an apples to apples comparison.  You are comparing two different indices.  Buying the Russell 2,000 doesn’t mean you’re “beating the market”.  It means you’re achieving the exact return of the small cap market.  And in doing so, you’re taking on a bit more risk to achieve a bit higher return than comparable indices like the S&P 500.  Again, none of these strategies account for risk adjusted returns and again compare apples to oranges.

The final approach is, by definition, matching the market.  John Bogle has been selling low fee index funds for years.  They match their correctly correlated market because that’s the index they’re tied to!

Beating the market isn’t easy.  Don’t be fooled otherwise.

 

 

Cullen Roche

Mr. Roche is the Founder of Orcam Financial Group, LLC. Orcam is a financial services firm offering research, private advisory, institutional consulting and educational services.

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Comments

  1. Low-cost equity index funds have generally beaten most actively managed equity funds over long time periods such as 10 and 15 years. Studies have shown that only about 20% or so of active equity fund managers actually beat their target index over a 10 year or more timeframe. Luck or skill or a combination can help you beat the index by a lot in a short timeframe, but luck tends to turn in longer timeframes.

    • No it’s neither. Most professional investors can beat the index GROSS of fees long term. The problem is that fees for actively managed funds are so high relative to alpha they are able to generate they under perform the index. If you assume at long term S&P returns are around 8% per year, a 1% management fee (which is generously low) would mean that the portfolio manager has to outperform his/her peers by 12.5% on an absolute basis just to break even every year, now that is a challenge!

    • What percent of golfers break par? Are the small percentage that do lucky or good?

      Most fund managers are not truly professionals. There are a handful out there that are. Find those and they’re worth what you pay them. Good investing isn’t as random as many people think.

  2. One consideration: Isn’t people trying to beat the index actually improving the index? Bad companies get thrown out and better companies are getting put in and all that stuff. If everyone was just indexing we’d all be holding the Dow Jones Average from 100 years ago.

  3. Hell no it’s not easy. Most would-be traders underestimate the amount of time and work it takes. But a private trader has one big advantage, a small finanacial footprint. Hard but not impossible.

  4. Very informative post and I agree with Cullen Roche. He said the right thing. There are many many companies. But this doesn’t mean that we have to necessarily act like stupid. We have to determine things anew. Thanks a lot.

  5. The financial services industry sells the fantasy that everyone can beat the market . . .

  6. The index also has a suvivorship bias that artificially increases returns as opposed to an invested passive index tracker / portfolio

  7. You ever going to start writing about portfolio construction for individual investors? I think you’ve mentioned you’d like to get around to it after you started Orcam.