that most part-time investors could not come close to duplicating, struggle to match the market’s performance by buying, holding, or selling individual stocks.
For instance, a study by Dalbar Inc. in 2003 showed that from 1984-2002 the average annual return of the S&P 500 was 12.2%, while the average annual return achieved by mutual fund managers was only 9.3%.
Nothing much has changed since.
Each year Standard & Poor’s issues its S&P Indices Versus Active Funds Scorecard (SPIVA). Its mid-year report last year showed that 89.8% of managed domestic stock funds failed to beat the performance of the benchmark S&P 500 Index over the previous 12 months. And over the past three and five years the numbers were 73.2% and 67.7% respectively, by far the majority.
But even worse, even if an investor happened to choose the best from the small minority of those who did beat the market in those individual years, the odds are high that they would seriously under-perform over the subsequent period.
For instance, there are more than 8,000 mutual funds available. In 2003 mutual fund tracking firm Morningstar conducted a study that broke the 20-year period of 1976-2002 into five four-year segments. It then compared the performance of the best 30 funds in each of those four-year periods with their performance over the next four-year period.
The results were not only revealing but astounding. The best 30 funds in each cycle averaged annual gains of 28.3% in the four-year period in which they led the pack. In the next four-year segment they not only dropped out of the top funds but averaged annual gains of only 1.8%, reverting to the mean or worse.
Yet, in spite of all the evidence that by far the majority of even full-time professionals cannot match the market’s performance, millions of individual investors persist in thinking they can select a portfolio of individual stocks that will beat the market (and also the professionals).
A recent study by Longboard Asset Management looked at the formidable odds of doing so from a different perspective. It compiled the returns of 3,000 stocks from 1983 to 2007. It shows that 39% of the stocks were unprofitable investments, 19% lost at least 75% of their value, 64% underperformed the market, and just 25% of the stocks were responsible for all of the market’s gains over the period.
But those popular lists of the 25 best stocks of the last three months, or the last year, or last three years, with their double-digit, often triple-digit gains, are enticing, convincing investors that somehow, with a little bit of luck, they can pick enough of those few big-winners out of the thousands of available stocks, beat the odds and do what even the professionals cannot do consistently, match or beat the market’s performance.
There is a better way.
The most obvious investing risk is that the market may not move in the expected direction, and when the overall market moves it tends to take the majority of stocks, good and bad, with it.
The second risk is sector risk. Even though the overall market may move in the expected direction, there will be some sectors that for one reason or another will move less, or even move in the opposite direction.
And finally, there is stock risk, the most challenging of the three. Even when an investor gets it right on both market and sector direction there are still too many individual stocks that run into totally unexpected problems of their own.
Therefore, at least one-third of investing risk, and probably more, can be eliminated by avoiding individual stocks altogether and simply investing in sector or market indexes via index mutual funds and ETF’s.
Simply investing in an S&P 500 index fund (NYSEARCA:SPY) on a buy and hold basis would allow investors to come very close to matching the market’s performance, which would beat the performance of by far the majority of professional managers, not a shabby accomplishment, on the surface anyway.
But that would also guarantee suffering through every serious correction and bear market that comes along. Very few, if any, buy and hold investors are able to do that, most becoming market-timers but with the worst of timing, bailing out of the strategy in disgust after experiencing large losses. And indeed the experiences of the last 12 years have provided a quite convincing argument for market-timing.
Fortunately, sector and market index funds and ETF’s provide their same lower-risk attributes when used in market-timing.
In my newsletter’s Seasonal Timing Strategy (which has significantly out-performed the market since introduced in 1999), we use the SPDR DJIA Index ETF (NYSEARCA:DIA) as the sole holding, rather than taking either sector or stock risk.
In our non-seasonal Market-Timing Strategy we use sector funds as well as index funds, avoiding individual stocks. As an example how the lower risk without sacrificing performance works, with a buy signal on the Transportation sector we bought the iShares Transportation ETF (NYSEARCA:IYT), in December rather than a selection of individual transportation stocks. The ETF is up more than 20% since. But FedEx Corporation (NYSE:FDX), one of the individual transportation stocks we may well have selected, shocked the market this week by announcing an unexpected 31% earnings decline, and the stock plunged almost 10% in just three days.
And it’s not just that the odds of much better performance increase significantly if individual stock-picking is avoided. Unless an investor is just throwing a dart, many hours of analyzing individual companies, their products, management, competition, and prospects, are saved that can be put to better use in other areas of your investment planning and decisions.
Just a thought.
Related: Dow Jones Industrial Average (INDEXDJX:.DJI).