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Kill the S&P 500

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Worldwide Invest Better Day 9/25/2012
The invention of the low-cost S&P 500 (INDEX: ^GSPC  ) index fund, as well as the pioneering SPDR S&P 500 ETF (NYSE: SPY  ) , is up there with the wheel, electric light bulb, Internet, and double-dip ice cream cones. But while it's a good thing for some purposes, it's become important far beyond reason. "Beating the S&P" has become the be-all and end-all of investing, the first words we hear out of the investing womb.

To that, we should say, "Horsefeathers, fiddle-faddle, and bunkum." The S&P 500 has become the bully that won't leave us alone. We must fight back, and David, as we know, can beat Goliath.

Do you really like your relatives?
Let's accept for the moment calendar-year stock market returns -- another bully down the block, but one at a time, please! In 2008, the S&P 500 total return was negative 37%. To beat the S&P 500, for relative return, all your portfolio had to do was lose 36%. Wow, how great would you feel? Manic? Or even pleased? I doubt it.

This is relative return: whether the return your investments produce is greater or lesser than the benchmark you set as a hurdle you must surmount to achieve your goal. And the S&P 500 is the performance benchmark used just about everywhere. It's still a bully, though. Just because everybody does it doesn't mean it's right. I mean, you know, your parents and the friends jumping off the bridge thing.

It's even worse when the mud hits the fan. In the great depressions and recessions, including the 1930s, 1973-1974, 2000-2002, and 2008-2009, do you think investors were happy beating the S&P 500 but still losing money on paper? Bet not.

Turning back the investing clock
Every major period of significant paper losses resets your investment clock, moving you back on the road to achieving your investment goals. But unlike with standard and daylight time in the U.S., when we "fall back" in October's investing fall, we don't "spring forward" in March's investing spring. Investing seasons defy the climate where you live.

To recover from a 33% paper loss, it actually takes a 50% gain; from $100 to $67 is 33%, but from $67 to $100 is 50%. You have huffed and puffed pushing a rock up the hill, but you skip and the rock falls back. Who knows how much effort and time is required to get back on track, and how much time do you have?

Forget your relatives.

To truly win, focus on absolute return, positive results over time. Why did people flock to Bernie Madoff's promised 12% a year? Guaranteed absolute returns! It was a rational decision to prefer absolute over relative, but it's not possible by calendar year, and only with the best managers on a long-term annualized basis. So Madoff, knowing this, cooked the books. And his cookbooks were all written by a guy named Ponzi, a really bad chef.

Beat up the market average bully: Dividends and DCA
The S&P 500 may be the biggest bully on the investing block, but it's got an army behind it. Other market averages from the Russells to Dows put up their dukes. So how do you subdue the relative-return bullies?

Pick stocks with many-year records of paying dividends and gradually increasing them without building up debt to pay for them or spending cash needed to maintain the business, and then reinvest each dividend received into the stock. My friend and fellow analyst The Motley Fool's James Early can help you find them when you join his disciplined and successful dividend service, Motley Fool Income Investor.

Consider another friend's investment decades ago in Merck (NYSE: MRK  ) . When she told me her story, Merck dividends had grown so that they paid her 35% a year on her initial investment. I don't care whether it's absolute, relative or inflation-beating (a major subject for another time) returns we're after, that's a winner. It didn't carry her whole portfolio because she practiced sound diversification, but it sure helped. Tons.

If you buy young and hold for decades, other stocks that have increased dividends for decades may just do the same for you: Johnson & Johnson, Coca-Cola, McDonald's, and Target, to name but a few. Find more great candidates from Motley Fool Pro analyst Bryan Hinmon here.

So let's say you are a disciplined dividend reinvestor who buys more stock with each quarter's payout or an index investor who buys more of the index with each paycheck in whatever your company's 401(k) offers. It's all simple dollar-cost averaging, or DCA, and the best way to absolute returns. But one big honking caveat: You have to buy at set, regular intervals and never waver.

Don't try to figure out when it's best to buy and stop doing so when you "think" it's a bad time. Go on autopilot. Buy with every quarterly dividend or with every paycheck, whether the market is crashing (allowing you to buy more shares and reduce your average cost) or zooming (buying fewer shares and increasing your average cost less). No one knows, really, whether it's doing either or for how long. Just keep doing it. Stiffen your spine, build your backbone.

Go forth, you have only your losses to lose!
Leave the lotus-eaters, question authority, and take on that bully. Seek tidy absolute returns over time and forget the averages. Unless you want to devote the 10 years on average it takes to be a good individual stock picker and give up home, hearth, and hobbies, stick to dollar-cost averaging and reinvesting dividends. Forget calendar-year and relative returns.

A story: In elementary school I feared the walk home from school, sure to run into Mark the bully every day for what seemed like forever. Taunting, standing in my way -- a general jerk. He'd toy with me, tire of it, and wander off with a parting insult to my boyhood.

One day, he just wouldn't let me pass. He taunted me to fight, with a free first shot. Great, elevated to a new and yet even more certain humiliating level. I prepared for doom.

But for some reason I'll never know, that day among all days and months, I'd had enough. Never having even attempted to hit, let alone actually hit, anyone in my short life, the time had come. I said, "All right," shut my eyes tightly, gathered my courage to prepare for certain death in response, and swung wildly in every direction. I felt something, but in my other-worldly state, who could be sure? Was it just the weight of the air against the uselessness of my fist?

Silence.

When it seemed safe, I opened my eyes slowly. Oh no! I had drawn blood! Mark rubbed his lip, stunned. This was not going to be good. I prepared to beg for mercy, to promise anything, but I never got the chance. He told me never to tell anyone and ran home.

That was it. The bully is only that. You can do it.

What do you think is a good measure of absolute returns, and over how long a time period? Let us know!

 

Tom Jacobs is lead advisor for Motley Fool Special Ops, a premium service offering a long-short investment portfolio serving up special situations and opportunistic values, spiced with a dash of earnings quality shorts. You'll see the S&P 500, but also that Special Ops' absolute returns (surprise!) are positive. The Motley Fool owns shares of Johnson & Johnson, Coca-Cola, and McDonald's. Motley Fool newsletter services have recommended buying shares of Coca-Cola, McDonald's, and Johnson & Johnson, as well as creating a diagonal call position in Johnson & Johnson and a bear put spread position in SPDR S&P 500 ETF. The Motley Fool has a disclosure policy.

We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. Try any of our Foolish newsletter services free for 30 days.


Read/Post Comments (5) | Recommend This Article (17)

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 September 13, 2012, at 3:57 PM, HectorLemans wrote:

    "To truly win, focus on absolute return, positive results over time."

    If you're consistently beating the S&P500, you will have positive results over time (say, 5 to 10 years) because the S&P500 has always risen over time. I think the reason most investors compare themselves to the S&P500 is to get an idea of how good they're doing short-term. Sure, if I lost 36% in 2008 I wouldn't be that happy. But if I only lost 10% or 15%, I'd know my investment strategy was solid.

  • Report this Comment On September 13, 2012, at 5:07 PM, hiddenflem wrote:

    If you can't beat it join it...

  • Report this Comment On September 13, 2012, at 7:33 PM, IdaAg wrote:

    You could easily say the inverse and ask how happy I would be if my stocks gained 12% while the S&P rose 37%, would I be happy then? NO! And while aiming for 12% is an admirable goal it doesn't mean you can reach it each year so you will still be disappointed in just as many years as you will be if you consistently beat the S&P 500.

  • Report this Comment On September 14, 2012, at 11:28 AM, pondee619 wrote:

    Start by killing this ad:

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  • Report this Comment On September 14, 2012, at 12:22 PM, talotu wrote:

    You lost me at paper losses, but this article is worthless on so many more levels.

    How did I feel when I beat the market in 2008? Actually pretty good even though I lost 20%.

    The reason is because when I matched the market when is subsequently doubled, instead of having 140% of the money I had at the start of 2008 I had 160%.

    DCA is a suboptimal strategy, paper losses are are a silly concept ("It doesn't matter whether your stock went from 100 to 10, as long as you don't sell they are only paper losses"), and people can talk a good game about absolute returns, but the only people "getting" smooth real returns are people like Madoff who are lying, or people who have their money in CDs.

    Any strategy that tries to beat CD returns will be lumpy, and will lose money in real terms over lengths of time.

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Tom Jacobs
TMFTomJacobs

Tom Jacobs is the Lead Advisor and Portfolio Manager for Motley Fool Special Ops, a premium investment service specializing in event-driven value situations such as spinoffs. He is the co-author of What's Behind the Numbers? A Guide to Exposing Financial Chicanery and Avoiding Huge Losses in Your Portfolio (McGraw-Hill). He doesn't bite, except when teased.

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