Jeremy Siegel, author of "Stocks for the Long-Run,” offered this ironic observation at the start of chapter 23: “there is a crucially important difference about investing compared with virtually any other competitive activity: Most of us have no chance of being as good as the group of individuals who practice for hours to hone their skills. But anyone can be as good as the average investor in the stock market with no practice at all.”
As he added, this surprising statement comes from the fact that the total of all holdings by investors must be equal to the market. And, the market’s performance must be the average dollar-weighted performance of all holdings by investors. As a result, for each investment dollar that outperforms the market, there must be another investment dollar that underperforms. Taken a step further, this means that by matching the market, investors are “guaranteed” to do no worse than average.
This has led some to the idea that if many novice or poorly prepared investors are losing money, then well-informed or professional investors should be able to outperform the market. However, that has not always been the case.
Siegel noted there were only 12 years in the previous 40 (1972-2102) when the majority of mutual funds (adjusted for survivorship) did better than the Wilshire 5000. Ten of those years occurred when small-cap stocks were outperforming large-cap stocks (many managers used small stocks to add growth potential to their portfolios).
However, some professionals consistently outperform; the biggest names among them include the Sequoia Fund, under the direction of Ruane, Cunniff, & Goldfarb, Peter Lynch of Fidelity Magellan and Warren Buffett (Trades, Portfolio) of Berkshire Hathaway (BRK.A, Financial)(BRK.B, Financial). Siegel pointed out that results such as those had to include skill and not just luck, based on statistical criteria.
He added, “But for more mortal portfolio managers, it is extremely difficult to determine with any degree of confidence whether the superior returns of money managers are due to skill or luck.” Finding outperforming managers is going to be a challenge, “a money manager would have to underperform the market by 4% a year for almost 15 years before you could be statistically certain (defined to mean being less than one chance in 20 of being wrong) the manager is actually poor and not just having bad luck. By that time, your assets would have fallen to half of what you would have had by indexing to the market.”
What about the idea of “hot hands,” that if managers had outperformed in the past that they will do it again in the future? Siegel noted the conclusions of “numerous” studies were inconsistent. This persistence may occur because managers follow a specific investing style and their outperformance, or underperformance, will last only so long as that style works or does not work.
In examining the reasons for underperformance, Siegel sounds the same notes as John Bogle, the founder of the first index fund and author of “Common Sense on Mutual Funds: New Imperatives for the Intelligent Investor.” Siegel starts with the fact that funds have fees and trading costs. First, a manager buys and sells stocks in a bid to earn superior returns; that means trading costs plus losses on the bid-asked spread. Second, investors pay management fees and, in some cases, get stuck with front-load or back-load fees which are commissions for the advisor who sold them. Finally, managers compete with other managers and because it is impossible for everyone to do better than average, some investors must underperform.
At greatest risk, according to Siegel, are novice investors or investors with just a little bit of knowledge; they’re likely to do worse than investors with no knowledge and decide to index their investments. Part of this may be the result of bad stock picking, but unchecked emotions can also damage the uninformed.
Even among informed investors, odds that they might outperform the market are small. That may be true for professionals as well; Siegel cites a study that showed, when transaction costs are considered, money managers “must outperform the market by margins that are not possible.” That study concluded with these words, “Contrary to their oft articulated goal of outperforming the market averages, investment managers are not beating the market; the market is beating them.”
It’s no surprise, then, that Siegel, like Buffett, thinks most investors would be well served by passively investing in one or more broad-based index funds. As many will recall, Buffett spoke these now-famous words in 1993, “By periodically investing in an index fund, for example, the know-nothing investor can actually outperform most investment professionals. Paradoxically, when 'dumb' money acknowledges its limitations, it ceases to be dumb.”
Nevertheless, Siegel wanted investors to distinguish among the types of index funds. He wrote that index funds based on capitalization weighting could cause problems for investors in the future. That’s because a company’s stock price will rise when the market expects it to be included in an index. In turn, that means some companies in the index will be overvalued.
As an extreme example, he offered Yahoo (since taken over by a subsidiary of Verizon (VZ, Financial)). Following the Nov. 30, 1999 announcement it would become part of the S&P 500, the stock jumped $9 overnight to $115 and kept going up, reaching $174 on Dec. 7 when index funds had to buy into it. And although few firms entering the index gained that much, every firm added does bring that effect to some extent.
Siegel would prefer fundamentally-weighted indexes, rather than those that are capitalization-weighted. A fundamentally-weighted index would be based on one of the basic fundamentals, such as earnings. Advantages include the avoidance of bubbles, where stocks prices rise without the benefit of increases in dividends, earnings or other objective metrics. In fact, he reported that fundamentally-weighted indexing began with the Japanese stock market bubble of the 1980s, as investors with international portfolios sought a way to reduce the weight of Japanese stocks in their portfolios.
According to Siegel, fundamentally-weighted indexes have outperformed capitalization-weighted indexes because of their emphasis on value-based strategies. Fundamentally-weighted indexes also offer better diversification and historically have had better risk-return trade-offs.
(This article is one in a series of chapter-by-chapter digests. To read more, and digests of other important investing books, go to this page.)
Disclosure: I do not own shares in any company listed, and do not expect to buy any in the next 72 hours.
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