The Secret You Need to Beat the Market

Fact: Index fund investors tend to do better than investors in actively managed mutual funds.

Is this because most mutual fund managers can't seem to get their acts together and beat the indexes? That's part of it. Is it because of the sometimes staggering fee differential between actively managed funds and passively managed index funds? That's definitely a big factor.

But the bottom line is that it doesn't much matter what kinds of after-fee returns actively managed funds are able to produce -- the sad fact is that most investors in those funds typically end up with significantly worse returns than what the fund actually generates. A 2007 study by Zero Alpha Group (ZAG) showed that, on average, index fund investors tend to lag the returns of their funds by 0.47% per year, while investors in actively managed funds lag by a whopping 1.7%.

While 1.7% may not sound like a lot, consider this: Over the course of 30 years, $250,000 turns into $4.36 million with 10% returns, but it reaches only $2.73 million with 8.3% returns.

Does $1.6 million strike you as something worth paying attention to?

No fluke
ZAG's study is hardly some wonky view that may or may not hold water. The tendency for mutual fund investors to underperform the funds they invest in is no big secret. The knowledge of this is so strong that it spawned a myth that half of the investors in Fidelity's Magellan Fund during Peter Lynch's tenure -- which produced 29% average annual returns -- actually lost money.

Though the Lynch/Magellan story may be apocryphal, the lesson from the real studies that have looked at this tendency is something that every investor needs to brand their gray matter with.

In simple terms, mutual fund investors underperform their funds because they are terrible at timing the market. They buy during ebullient times when everything's frothy and then have a tendency to sell when panic is in the air and blood is running in the streets. Buy high and sell low is always a recipe for disappointment.

But why doesn't this happen to index fund investors to the same extent? It's because, for the most part, they don't bother trying to time the market. By investing in index funds in the first place, this set of investors has basically said, "I give up, I'm just going to take the market's returns and call it a day." So it's not all that surprising that they don't bother hopping in and out of their investments.

Indexes aren't perfect
Though I do not subscribe to the efficient markets theory -- which is often used as a reason to invest in index funds -- I do think that index funds can be a great vehicle for many investors. In fact, when it comes to emerging-market exposure, I prefer to use an index fund myself because, though I see the opportunity in those markets, I don't feel like I can get enough insight into the companies to invest in them individually.

However, there are drawbacks to investing in indexes. For one, most of the major ones weight the holdings based on size, so the bigger a company gets -- regardless of whether that comes from profit growth or a runaway valuation -- the more of it the index will own.

An example of how this can get out of hand is the recent Nasdaq 100 rebalance. Prior to the rebalance, Apple (Nasdaq: AAPL  ) accounted for more than 20% of the index. Investors thinking that a 100-stock index would give them good diversification likely had no idea how much their investment was set to live and die on the fortunes of one company.

In addition, by their nature, indexes invest in everything within certain bounds. So if I buy an S&P 500 index fund, I'm getting shares of Southwest even though as a rule I don't invest in airlines (even though Southwest may be the best of the bunch). In addition, I'll end up with shares of Netflix (Nasdaq: NFLX  ) , even though I think that the near-50 forward price-to-earnings multiple means that low returns are ahead (though my fellow Fools at Motley Fool Stock Advisor disagree).

That's why, when it comes to investing in U.S. and multinational companies, I prefer to pick out individual stocks that have more attractive characteristics -- lower valuation, higher dividends, better business -- than the average index fund holding.

Patience: Not just for index funds
I recently wrote an article "5 Stocks for the Next Three Decades." It wasn't meant to simply be a clever, eye-catching title. My intent was for readers to really think about what it would mean to own a stock for 30 years.

Think that sounds crazy? Many large, well-known companies have produced very impressive dividend-adjusted returns over the past 30 years. ExxonMobil (NYSE: XOM  ) returned 14% per year, General Electric (NYSE: GE  ) delivered 12.6% per year, and Merck (NYSE: MRK  ) managed 12.9% per year.

Of course it's been anything but a straight line for these stocks over the three-decade span, and there were plenty of opportunities for investors to buy high, sell low, and shoot themselves in the foot.

But what if we approached investing in individual companies the way index fund investors view their investments? Granted, when it comes to individual companies you can't ignore significant changes in the business that make it unattractive. But what happens when you shut out the Wall Street and media circus and hang onto a high-quality stock for years and years, if not decades?

As is usually the case, we could do worse than using Warren Buffett as an example. Twenty years ago, Coca-Cola, Gillette (now owned by Procter & Gamble), GEICO (now fully owned by Berkshire Hathaway (NYSE: BRK-B  ) ), The Washington Post Co., and Wells Fargo (NYSE: WFC  ) were five of Berkshire Hathaway's seven largest holdings. Buffett has seen fit to continue owning a significant stake in all of these companies.

Of course, it all seems too simple right? With all of the thick books and countless hours of TV coverage of experts opining on the ins and outs of investing, could it be that patience is really the missing ingredient for most investors? Head down to the comment section and let me know what you think.

Looking for companies worth owning for the really long run? The free special report "13 High-Yielding Stocks to Buy Today" is a great place to start.

Berkshire Hathaway and Coca-Cola are Motley Fool Inside Value choices. Apple, Berkshire Hathaway, Southwest Airlines, and Netflix are Motley Fool Stock Advisor recommendations. Coca-Cola and Procter & Gamble are Motley Fool Income Investor recommendations. Alpha Newsletter Account, LLC has bought puts on Netflix. Motley Fool Options has recommended a bull call spread position on Apple. The Fool owns shares of Apple, Berkshire Hathaway, Coca-Cola, ExxonMobil, and Wells Fargo. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors.

Fool contributor Matt Koppenheffer owns shares of Berkshire Hathaway, but does not have a financial interest in any of the other companies mentioned. You can check out what Matt is keeping an eye on by visiting his CAPS portfolio, or you can follow Matt on Twitter @KoppTheFool or on his RSS feed. The Fool's disclosure policy prefers dividends over a sharp stick in the eye.


Read/Post Comments (18) | Recommend This Article (18)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On May 11, 2011, at 5:26 PM, TheDumbMoney wrote:

    hey, truth, long time no see!

  • Report this Comment On May 11, 2011, at 8:57 PM, TMFKopp wrote:

    @truthisntstupid

    With enough patience, you eventually may have an effective negative starting price. Then you can have some interesting calcs determining the return of your next dividend on your negative effective starting price :)

    Matt

  • Report this Comment On May 11, 2011, at 9:23 PM, TMFKopp wrote:

    @truth

    Yeah, I guess I was thinking more about real life... though I'd be very impressed if you hung onto your CAPS picks long enough to get to zero! (or theoretically so at least...)

    Matt

  • Report this Comment On May 11, 2011, at 9:31 PM, HarryCaraysGhost wrote:

    Hi Truth,

    Thanks I always wondered how Divis were calculated on Caps. I wanted you to take a look at a profile that is divi heavy, I'm content to let it ride for the long haul and think it should do well.

    This is close to what my port would look like if I had a million dolars . Maybe a few more MLP's in real life.

    Ok cat's out of the bag I'm Scruffy.

    Type in sruffy4life under find players, and yes this is another Futurama referance.

    Cheers,

    Harry.

  • Report this Comment On May 11, 2011, at 10:18 PM, portefeuille wrote:

    2 correction factors make sense.

    --------------

    price goes from a to the theoretical "ex-dividend price" a - d, so it is multiplied by (a - d)/a = 1 - d/a =: cf1. multiplying the starting price with the same factor ensures that the performance is "continuous at the ex-dividend date".

    --------------

    --------------

    using the dividend to buy shares at the open of the ex-dividend date you get d/e shares, where e is the ex-dividend price. as the number of shares is multiplied by (1 + d/e), the starting price is multiplied by 1/(1 + d/e) =: cf2.

    --------------

    for e = a - d you get cf2 = 1/(1 + d/(a - d)) = 1 - d/a = cf1, as it should be ...

    --------------

  • Report this Comment On May 11, 2011, at 10:26 PM, HarryCaraysGhost wrote:

    I'm glad you like Scruffy, I wanted that avatar so bad. It was a mission : )

    I have some good divi news on my RL port. When you break down Budweisers annual payout it comes to .29 a share/ pr qtr.

    Since I started buying shares at $17 and stopped at $40, not a bad investment at all.

    And Visa has upped the divi every year. Since those are my two largest holdings I feel comfortable calling myself a dividend investor. I do like to diversify with my smaller holdings though ;)

  • Report this Comment On May 11, 2011, at 10:38 PM, HarryCaraysGhost wrote:

    Sorry Matt, did'nt mean to take your article off on a tangent : ) I always enjoy discussing dividends with Truth, and I forgot that this was your article.

    All the best.

  • Report this Comment On May 12, 2011, at 12:08 AM, HarryCaraysGhost wrote:

    Hey Truth if your still there, maybe we could continue the conversation.

    I just forgot that we were using Matts article, I doubt he would mind. I just did'nt want to be presumptious.

    I would be interested in knowing what your candidates for the stock that is deemed worthy of owning 100 Shares of are. I suspect your waiting for 2012 which makes perfect sense in my mind

  • Report this Comment On May 12, 2011, at 12:37 AM, TMFKopp wrote:

    ^

    You two are hilarious!

    Matt

  • Report this Comment On May 12, 2011, at 2:57 AM, HarryCaraysGhost wrote:

    And I still insist that it's easy.>>

    Yeah, I know man, but do we really want to put that out there so everyone knows... ;)

    DIVIS ROCK. I just got alot of my divis in for the last qtr and Bud goes yearly, I know you don't do this but I'll be reinvesting, maybe in a penny stock, maybe in a commoditty. This is not an advisable strategy-

    But hey it works for me. (any novice investors reading this, please run away now I base my investment strategy on Hunter S Thompson)

  • Report this Comment On May 12, 2011, at 8:13 AM, portefeuille wrote:

    1 - d/a =: cf1

    --------------

    This is the correction factor you get if you reinvest the dividend at the close of the day preceding the ex-dividend day. For 1 share you need to buy c := a/(a - d) shares at the close, where a is the closing price and d is the dividend per share again.

    -> 1 + x = 1/(1 - d/a) -> 1/(1 + x) = 1 - d/a = cf1.

    As it should be you can afford to buy exactly those x shares for every share you own at the close, as (1 + x)*d/a = x ...

  • Report this Comment On May 12, 2011, at 8:16 AM, portefeuille wrote:

    So whether you prefer cf1 or cf2 depends on whether you assume dividend reinvestment at the close of day n-1 or at the open of day n ...

    (To buy at the close you would need to know the closing price in advance, which is usually not possible, so the using cf2 (as in the "caps" game) might "make more sense", hehe ...).

  • Report this Comment On May 12, 2011, at 8:18 AM, portefeuille wrote:

    done with kindergarten mathematics ...

  • Report this Comment On May 12, 2011, at 9:50 AM, pastreet wrote:

    You know what else is important: Keeping the faith in the companies you own. Buy and hold is not the way... buy and own is a more apt description. Don't sell your company unless A) you get an offer you cant refuse, or B) you think it is going to be worth less or make less money in the future, or C) you can use the capital better elsewhere.

    Pat

    www.compoundingreturns.com

  • Report this Comment On May 12, 2011, at 10:22 AM, portefeuille wrote:

    the using ->

    using

  • Report this Comment On May 12, 2011, at 10:38 AM, David369 wrote:

    pastreet

    good point. More realistic/profitable

  • Report this Comment On May 12, 2011, at 1:30 PM, TMFKopp wrote:

    @truth

    I can honestly say that I haven't taken the time to ponder the intricacies of stock price adjustments for dividends in CAPS. Mostly I've just trusted that our folks got it right.

    Of course whether we're talking CAPS or Yahoo!Finance, the calculation will have to be done with the assumption of a specific action in mind (reinvesting, keeping as cash). But of course one of the great things about dividends is that they're cash and in our real portfolios we can do whatever we want with them.

    I think at some point I'm just going to get mine paid to me in small change and start filling up an Uncle-Scrooge-style swimming pool so that I can bathe in my dividends. But that's just me...

    @pastreet

    I think semantically "buy and own" does do a better job at describing it since the idea is that you're owning a (hopefully) high-quality business.

    As to your three points though, while I'm technically in agreement, this is where it gets tricky and I'd refer back to my article above. Actively-managed mutual fund investors have underperformed the funds they invest in precisely because they believe they constantly see better places for their capital. And it's the jumping around to the next thing, and the next thing, and the next thing that leaves them chasing their tails.

    I think there's a middle ground between the two. Blindly holding (or owning) for decades is obviously not ideal. But neither is having an itchy trigger finger.

    Matt

  • Report this Comment On May 13, 2011, at 6:29 PM, pryan37bb wrote:

    Don't mean to detract from the divvy conversation going on right now (I'm a big fan myself: long VZ and MO), but with regards to the topic of passive funds, one strategy I've been considering is starting a position in, for example, the IWM, the iShares Russell 2000 Small Cap Index, and writing monthly OTM calls and puts against it. That income would compensate for the expense ratio, small though it might be, as well as add some income to the rather weak dividend yield. On top of that, it would help encourage a buy-low, sell-high discipline, such that if the index runs up, you would get called away and lock in a profit, and if it falls substantially, the shares get put to you at a discount to the price at which the position was started. What do you guys think about writing options to supplement dividend income?

    And getting back to dividends, what do you guys think of National Presto, NPK?

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