The Fool and other media constantly promote the fact that something like 70% to 90% of all managed mutual funds underperform the S&P 500 index. If one considers managed mutual funds with more than 10 years of operating history, and includes expenses, I'm sure the number that beat the index is far less than 10%. However, rather than dismiss this as a reason to invest only in index funds, why not investigate who has beaten the S&P 500 index for long periods of time, expenses included?
I'm an avid reader of financial literature, and know my way through a balance sheet, cash flow statement, and income statement. I think my psychology is also adequate for equity investing. However, regardless of how much effort I put in, I have come to the conclusion that my investing insight and skills will never be nearly as successful as the most talented people in the field. Because I have about one-millionth the assets of Buffet and Munger, does that give me enough edge so that there's a good probability that I can beat them at their game? If Michael Jordon gets the flu and sprains his ankle, does that mean I now have a good chance to beat him one on one? For myself, the answer to both is "no." That doesn't mean I've given up on stock picking, or playing basketball. It just means I'm aware of my limitations, and play those games accordingly.
I've believed in the index philosophy for the better part of the last six years, with roughly 50% of my savings in an S&P 500 index fund. However, mid last year I changed my tune and moved this money out of the index. The reason is that I have read too many logical arguments that support the extent to which the S&P index is overvalued. Perhaps the best assessment of this that I have seen was in the July 31, 2000 edition of Outstanding Investor's Digest (OID). Jeremy Grantham, of Grantham Mayo Van Otterloo, gave a presentation that in OID is titled "Bubbles have always given back everything. There have been no exceptions -- none." This article supplies excellent data that illustrated the overvaluation of the market in 2000. However, most of the parameters that Grantham presented in 2000 still indicate significant overvaluation today. For OID members, this article can be downloaded from the OID website, otherwise, I'm guessing it can be obtained from Grantham Mayo Van Otterloo's website.
One parameter for estimating the "value" of the S&P 500 index is P/E. Unless put in the proper context, any given Price/Earnings estimate can be very misleading for an individual company. However, for the market as a whole, I think P/E holds more water. The 30-year average P/E is 14. Currently it's in the mid 20s. Just with this information alone, one has to propose that one of the following three generalities applies to the P/E of the S&P 500:
1. The average P/E of the S&P 500 will not return to historical levels. Perhaps history will not repeat itself. There are more people in the market, so perhaps that has permanently driven up the demand for, and value of, equities. The weighting of the S&P 500 is different, more towards technology, and perhaps this could result in a permanent increase in P/E.
2. Earnings as a whole will start to increase faster than price, and Warren Buffett's predictions for growth (over the next decade) are too low. Of course this is a possibility, and there have been periods in the past where earnings have grown faster than price for long periods of time. However, in our trigger-happy society, it's hard for me to imagine a future where earnings rise faster than prices for long periods of time. But it's possible.
3. Prices will come down faster than earnings. Buffett has estimated relatively slow growth for the next decade or so. This, combined with the fact that the market is still historically overvalued, does not make a good case for S&P 500 indexing over the next decade.
I don't know which of these scenarios will arise. However, in my mind, the odds are not strongly in favor of the S&P 500 index resulting in a reasonable rate of return for the next many years. If you consider long term to be 20-30 years, and you don't care what happens for the next 10, then perhaps you won't be disappointed. And perhaps case 1 or 2 will turn out to be reality. But for me, the odds are not good enough.
My personal solution was/is to look for those few fund managers that have beaten the S&P 500 index over periods of 10 years or more. Instead of saying 90% of managed funds can't beat the index and throwing in the towel, I'm choosing to look at those who have beaten the index. The list is much smaller than I thought it would be... (continued)
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