Is Beating the Market Possible?

AUGUST 10, 2016
Benjamin Sullivan, EA, CFP

Beating the market is very difficult, but it can be done in some markets, such as small companies and emerging countries. In these smaller, less efficient markets, there’s a decent chance that a top-notch active fund manager can outperform the index over the long term.

Forget about market timing; it’s far too risky. Instead, build your overall portfolio by setting a long-term asset allocation and maintain this allocation by rebalancing regularly.

Only 19% of stock mutual funds and 8 percent of bond mutual funds survived and outperformed their indexes for the 15 years ending December 31, 2014.* Why not just buy one of those outperforming funds? They might provide a starting point, but there’s little correlation between past and future outperformance. Market timing backfires more often than it works. Whenever the stock market tumbles, people naturally want to take action to alleviate the pain, yet no action is often best reaction.

Trying to avoid the next market meltdown or identify the next hot market is a siren song that lured many investors to the rocks. Few people thought stocks in early 2009 were a bargain. However, be aware that cheap markets can get cheaper, and frothy markets can get more expensive. Buying securities that have declined a lot doesn’t portend success. An investment that has fallen 50 percent may very well decline another 90 percent.

A leading theory of valuation says that each investment has an intrinsic value, which can be determined through due diligence. Investors try to determine the correct price of an investment based on the current value of its future cash flow. But the future cash flow of most investments is uncertain, and even carefully researched projections can vary widely.

Market Efficiency Varies

Every time a trade occurs, it affirms that two parties agreed on the fair market value of the investment at that time. The market thus incorporates the collective wisdom of all investors’ different predictions of the future.

The degree to which market prices are accurate and mispricings are unpredictable represents that market’s efficiency. Markets with more participants, a freer flow of information, better-informed participants and more trading tend to be more efficient than markets that lack these features. Large-cap markets in developed countries are quite efficient.

In efficient markets, you’re better off using low-cost index funds. It’s very hard for active mutual fund managers to add value in efficient markets because mispricings are usually random.

Where to Use Active Management

In inefficient markets, mispricings often are not random because some investors have better information than others. A skilled fund manager with analysts on the ground can exploit inefficiencies to uncover hidden gems and potentially outperform the market.

I recommend indexing about 60 percent of your equity portfolio: mainly large-cap stocks in the US, Europe, Canada and Japan. Choose actively managed funds for the remaining 40 percent, including emerging markets and some smaller-company stock in the US and abroad.

Asset Allocation and Rebalancing

But before deciding whether to use passive or active management, you need to first set your overall asset allocation—a basic split between equities and bonds.  What’s best depends on the individual.

For a young person, an 80-20 split might be appropriate. For a very conservative retired couple, 20 percent stocks and 80 percent bonds might be optimal. Don’t try to time the market. Stick with your asset allocation unless your financial goals or situation changes.

Next, divide up your equities. I recommend putting 40 percent in passive US large large-cap funds, 10 percent in US small cap, 7.5 percent in natural resources, 7.5 percent in REITs, and 35 percent in international funds.

When rising markets lead to an overconcentration in one area, this is a signal to reduce your stake in that area to its original target percentage. Similarly, when underperformance leads to a significant under-concentration, buy more to get back to target. Suppose your small-cap allocation has outperformed and grown from 10 percent of equities to 15 percent. You should sell that 5 percent share and allocate it to other investments that are now underrepresented. Rebalancing the portfolio should be a key part of your investment strategy. It’s one of the best hopes for automatically buying low and selling high. Plenty of research suggests that disciplined rebalancing provides a higher risk-adjusted return than leaving a portfolio to its own devices.
Combining the practices of creating an asset allocation, rebalancing, and using both indexing and active management provides a way to reduce risk and get good returns—and, hopefully, beat the market with part of your portfolio.

*Source: Dimensional Fund Advisors and the Center for Research in Security Prices at the University of Chicago.
 
 

Benjamin Sullivan is a portfolio manager with Palisades Hudson Financial Group, based in Austin, Texas. He holds the IRS Enrolled Agent (EA) and Certified Financial Planner (CFP®) designations.
Palisades Hudson (www.palisadeshudson.com) is a fee-only financial planning firm and investment manager based in Scarsdale, N.Y., with more than $1.1 billion under management. Branch offices are in Atlanta; Austin, Texas; Fort Lauderdale, Florida, and Portland, Oregon.

Read Palisades Hudson’s daily column on personal finance, economics and other topics at http://palisadeshudson.com/insights/current-commentary. Twitter: @palisadeshudson.

 


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