Mar 31 2009
I Can Beat The Market
Recently, I was confronted on this blog and on another blog with the legitimate question, why would I want to use ETFs to build a portfolio when I can select the best stocks out of an ETF and avoid the laggards? This question is so logical and makes so much sense that the vast majority of investors plow right ahead and continue to select individual stocks to populate their portfolios without doing further research.
It is almost impossible to answer this question honestly. We certainly have the performance records of active mutual fund money managers. However, that is not a true test for the small investor as we are not buying stocks in such large amounts as to impact the bid-ask spread. Mutual fund managers do not have this luxury. Further, the small investor can be nimble in their decisions to buy and sell. The big advantage to the private or small investor is that we are not subtracting all the overhead expenses from the performance percentage. If we accounted for our time, telecommunication expenses, magazines, books, electricity, heating, computer costs, etc., I doubt any of us would perform better than the VTSMX index fund.
Gathering sufficient data on hundreds of private investors is nearly impossible, and that is what needs to be done to answer this probing question. The studies that have been done do not place the small investor in a good light.
I have a few bits and pieces of data to report and readers may find some of this interesting. As some of you know, I was involved in a five-year wager where I was to use a conservative stock picking software program and compare the results with the VTSMX benchmark. Actually, the wager was that the software program, if followed carefully, would double ones money in five years. Well – that did not happen. Moments ago I checked the five-year performance figures and the stock portfolio generated a five-year Internal Rate of Return (IRR) of 1.9% while the IRR for VTSMX was 0.7%. That 1.2% advantage to the stock program is not trivial. So there we have one example of stock selection outperforming an index fund.
It just so happens that I also have data over the same five-year period for a portfolio built entirely using ETFs. Over on the Premium Content side of the blog this portfolio is known as the Passive Portfolio (PP) as there is almost no trading. Over the same dates — 10/31/2003 through 10/31/2008, the PP outperformed the VTSMX index by 1.4%. So here we have the stock portfolio doing better than the index by 1.2% while a portfolio stocked with ETFs managed a 1.4% advantage. I would call that a statistical dead heat.
I do happen to have a second portfolio packed with ETFs and this portfolio, known as Projects (you will find it on the Portfolio Performance Summary), is doing better than the VTSMX benchmark over the same five-year October to October period by 4.74% points. Yes, that is an annualized percentage figure. To be truthful, the reason this portfolio is doing so much better than the benchmark is due to a large holding in cash, and cash has been king in this bear market.
Here is one more comparison readers will find interesting. Of the seven portfolios tracked over on Premium, five contain individual stocks that come from or were members of the “Creme List” when they were added to the portfolio. This morning I ran down through the 25 stocks (some were the same stock in a different portfolio) to see if they were performing better than the portfolio as a whole, or were they dragging down the portfolio. Of the 25 stocks, 13 were adding value to the portfolio while 12 were a drag on the portfolio. I found it interesting that at times the same stock was helping one portfolio while hindering another portfolio. It depended on the portfolio and when the stock was purchased. Again, I would call it a statistical draw.
These few stories certainly do not answer the nagging question of whether it is better to build a portfolio through the use of individual stock picking or whether one is well advised to construct a portfolio around a wide array of index investments such as ETFs. From all my reading and personal experience, I conclude that one is better off to build the core of a portfolio around index investments, and then pepper the portfolio with a few stocks of interest rather than the reverse process.
If you are conflicted as to which path to take when developing your portfolio, take another look at the Portfolio Summary Update I posted yesterday. Note that of the eleven portfolios, nine are performing better than the Vanguard Total Market Index Fund. If this does not convince you, then I challenge the reader to set up two portfolios. Build one portfolio by picking stocks. Create the second portfolio using an array of ETFs as suggested in this blog. Then track the performance of each using the TLH spreadsheet. This will give you some basis on which to make a rational decision.
Can you beat the market? Check out this article.
Do a search for Benjamin Graham on this blog and read those posts. Even Graham, near the end of his life, recognized the market is efficient.
I ran into this interesting link by clicking on the Sphere at the bottom of this post. Check it out.
Lowell Herr
Photograph: The Potala Palace – Lhasa, Tibet
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