When two essentially accurate statements conflict, there's usually a lesson to be learned. Consider these two arguments:
• Trying to pick individual stocks is a loser's game. Supporters of this argument point to countless studies that show that active mutual funds, on average, consistently underperform comparable index funds. If highly paid professionals with teams of researchers can't beat the market, what chance does an individual investor have?
• Investors throwing darts at a wall covered with the names of S&P 500 Index stocks should, on average, outperform the S&P 500 Index. Supporters of this argument point to the S&P 500 Equal Weight Index, which since its 2003 launch has handily outperformed the capitalization-weighted S&P 500 Index. The Equal Weight Index, which has also vastly outperformed in back-tests to the 1960s, holds all 500 stocks in equal proportions, rebalancing on a quarterly basis. If the Equal Weight index typically outperforms the capitalization-weighted index, that means the typical S&P 500 stock outperforms the index, on average.
How can both these arguments be correct?
First, mutual funds face a lot of built-in disadvantages. In fact, several studies from 2013 show that 80% or more of equity fund managers outperform their benchmark until fees and costs are considered. Other studies have shown that truly active fund managers — those willing and able to depart from their benchmark — outperform those that hew close to their benchmark. One problem: Funds that outperform tend to become popular, which brings disadvantages that go beyond expenses. C. Thomas Howard, the director of research at AthenaInvest, identifies three:
• Asset bloat. As funds get bigger, it becomes harder for managers to deliver superior returns, partly because they must stick to truly liquid stocks.
• Closet-indexing. Once a fund has established a good record and gathered a lot of assets, its incentives change. Delivering top-notch returns is no longer imperative. For fund-company profits, what matters most is avoiding a run of bad performance that will drive money out of the fund.
• Over-diversification. Howard says most of a manager's superior returns come from his or her 20 favorite stocks. But funds with a lot of assets or those worried about short-term performance droughts cannot afford to risk holding just 20 or 30 stocks.
Second, fund managers make the same mistakes that fund investors make, becoming too aggressive in giddy times and too timid in panicky periods. According to Dalbar, a research company, the average fund investor penalizes his or her return by 1.5% annually by selling when prices are low and buying when prices are high. While most funds avoid big cash positions nowadays, they rotate into defensive and aggressive stocks based on the same cycles of fear and greed that affect all investors.
Third, the Equal Weight Index has more exposure to smaller companies and value stocks, which tend to have higher returns — and higher risk. Over the last 10 years, the Equal-Weight Index has shown more monthly volatility than the S&P 500 Index. Still, researchers have shown that a variety of weighing schemes — from simulated dart-throwing monkeys to indexes based on the Scrabble values of ticker symbols — would have outperformed a capitalization-weighted index.
Note that none of these simple-minded indexes chased the hottest stock, rushed to lock in gains on winners, deferred taking losses on losers, or abandoned the market entirely when things got tough. In other words, they avoided the mistakes that tend to penalize individuals most.
Picking individual stocks does not need to be a losers' game. In fact, as an individual that does not need to manage billions or report returns every quarter, the odds are on your side — if you can avoid the emotional pitfalls that penalize the returns of most investors.
Be disciplined, monitoring how your portfolio is departing from one based on a rules-based methodology. And be humble, realizing that it's tough to predict the future. For our money, that means avoiding timing the market in an all-nothing fashion. From our perspective, holding about 20% of our equity portfolios in a short-term bond fund is a significant bet. Even though the Dow Theory is in the bearish camp, stocks are somewhat expensive, and corporate profits are falling, we're not going to exit the market entirely.