The investment strategy that beats the average investor – I

“Which mutual fund should I invest in?” is one of the most frequent questions that I get in daily conversation and through this site. Typically, those asking the questions have two things in common:

  1. you don’t have the time and / or interest in analyzing and picking individual stocks like here
  2. you’re looking for relative conservatism in the equity investing universe

I’ll answer this question across two posts; the why and the how

To start of I must say, I’m not a fan of mutual funds, especially the actively managed open-ended variety (which the bulk of funds are). This is evident from the relatively few mentions of mutual funds on this site, but do read The trouble with mutual funds that has painstaking analysis of the performance of mutual funds in India over 10 years.

In a nutshell, what makes mutual fund investing difficult:

  • Big variability in returns in any given year from mutual funds following the same investment philosophy
  • Funds that perform well over a few years usually under-perform subsequently (reversion to the mean)
  • Because of how an equity  mutual fund is structured, during a market sell-off, redemption pressure forces fund managers to sell good stocks at low prices which hurt returns for those who stay invested

The first two points make it extremely hard to pick a good mutual fund out of the hundreds out there and the third leaves the fund manager pandering to the whims of Mr. Market.

So does it mean every investor interested in equities but not willing to do the groundwork has to resign herself to sub-par returns from fixed deposits? No.

For the investor not taken by the idea of researching companies, examining balance sheets, evaluating pricing power and industry competitiveness, low cost passive indexing is an excellent investment strategy

Investing: Roulette table or fitness program

Investing is often likened to betting at a roulette table or on horses at a derby, where only those who pick the right number or horse “win”. This zero-sum view of the world causes millions to engage in value-destroying practices like day-trading, investing on “tips” or based on listening to the talking heads on CNBC. Observing investor behaviour, one would almost think that watching a friend’s portfolio outperform yours is one of the most painful things an investor can experience. Instead, here’s an alternate view…

It helps to think of investing as a fitness regimen meant to improve the state of your health. A brisk morning walk as part of your daily routine offers significant advantages, but irregular and haphazard sessions in the gym lifting massive weights with poor form will probably land you in hospital

Shoveling chunks of money into the market because the outlook for equities is great, selling at the sign of a decline, chasing trends and “hot” sectors all amount to deciding to go the gym one fine random day and trying to bench press your weight. All you’re likely to achieve is a hernia, or the belief that equity investing is a suckers’ game.

Enter passive indexing

Passive indexing is that regular morning walk that will have a telling impact on your financial health in the long run, with only a fraction of the aggravation of the punter trying to guess the winning number. Simply put, passive indexing takes away any guesswork at finding the “right” set of stocks and invests in the entire market, or almost all of it, regardless of whether cycles are at a peak or central bankers feel hawkish, dovish or any other kind of winged creature. The key is being regular and relentless.

It involves:

  1. selecting the index you want to invest in (the S&P 500 in the US, FTSE 100 in UK, Sensex or Nifty in India etc.) – the specifics of the vehicle to use are the topic of the next post
  2. setting up a regular (preferably monthly) investment for a period of atleast 1 year
  3. forget about the stock market, unsubscribe from financial newspapers and tv channels
  4. at the end of each year, increase the amount you invest by a percentage at least equal to your income growth. rinse-repeat.

Sure this means less time spent fretting over whether you have chosen the right investments and that you’re doing enough. But what of the returns lost from not being, well, active?

Maybe active investment management to you conjures images of brilliant mathematicians applying complex analysis to design the optimal market-beating portfolioBeautiful Mind

Or maybe the idea of pursuing superior returns makes you feel like a king, like this vintage ad for a mutual fund suggests:

Turns out ‘Passive’ beats ‘Active’

Humans always have believed in magic and miracles, and investors will probably never stop hoping to find the next Warren Buffett under some rock. – Jason Zweig, The decline and fall of fund managers

A growing body of research suggests that not only is passive investing less time-consuming and easy, it also beats active investing once you take into account the costs and taxes involved. And this isn’t fly-by-night studies funded by the passive indexing industry, but reputed academics who say that active investing isn’t worth the effort.

In his paper ‘Indexed Investing: A prosaic way to beat the average investor‘, William Sharpe (yes, of Sharpe ratio fame) gently recommends the use of indexing as a means of getting  steady investment returns

“Let me conclude with the obvious question: Should everyone index everything?  The answer is resoundingly no.  In fact, if everyone indexed, capital markets would cease to provide the relatively efficient security prices that make indexing an attractive strategy for some investors.  All the research undertaken by active managers keeps prices closer to values, enabling indexed investors to catch a free ride without paying the costs. Thus there is a fragile equilibrium in which some investors choose to index some or all of their money, while the rest continue to search for mispriced securities.

Should you index at least some of your portfolio? This is up to you.  I only suggest that you consider the option.  In the long run this boring approach can give you more time for more interesting activities such as music, art, literature, sports, and so on.  And it very well may leave you with more money as well.”

I particularly love that last line about being able to do more with your life by choosing the passive indexing approach, especially since it’s #5 on our list of calm investing principles.

In another paper, with a more dramatic title, ‘The Rise and Fall of performance investing‘, Charles D Ellis makes a much more direct case against active management by making three points (the complete paper is accessible below in ‘further reading’):

  • Active managers today have access to better analytical tools and techniques than ever before

“They have more-advanced training than their predecessors, better analytical tools, and faster access to more information. Thus, the skill and effectiveness of active managers as a group have risen continuously for more than half a century, producing an increasingly expert and successful (or “efficient”) price discovery market mechanism.”

  • However, since information is now freely available, arbitrage opportunities are fewer and short-lived

“The unsurprising result of the global commoditization of insight and information and of all the competition: The increasing efficiency of modern stock markets makes it harder to match them and much harder to beat them—particularly after covering costs and fees.”

  • Increasing availability of low-cost passive funds will be increasingly preferred over active management

“Now, with the proliferation of low-cost index funds and exchange-traded funds (ETFs) as plain “commodity” products, there are proven alternatives to active investing. And active managers continue to fail to outperform.”

In summary

If you don’t take pleasure in the process of identifying and shortlisting investments, passive index investing combines the best of both worlds; low involvement of time and effort with returns comparable and often superior to active management. You won’t “beat the market”, as very few do on a consistent basis, but you will beat the average investor.

In part 2, we look at the indexing options available to Indian investors….click here

Further reading:

The investment strategy that beats the average investor II – The Calm Investor

Five reasons why you’ll love index investing – Monevator

The decline and fall of fund managers – Jason Zweig

Indexed investing: A prosaic way to beat the market – William Sharpe

The rise and fall of performance investing – Charles D Ellis, CFA

8 thoughts on “The investment strategy that beats the average investor – I

  • March 1, 2015 at 2:31 pm

    Benjamin Graham was a scholar and financial analyst who mentored legendary investors such as Warren Buffett, William J. Ruane, Irving Kahn and Walter J. Schloss.

    Warren Buffett once wrote a lengthy article explaining how Graham’s principles are everlasting, and how Graham’s record of creating exceptional investors (such as Buffett himself) is unquestionable. The article is called The Superinvestors of Graham-and-Doddsville.

    Buffett describes Graham’s book – The Intelligent Investor – as “by far the best book about investing ever written” (in its preface, which Buffett wrote). In The Intelligent Investor, Graham recommended various categories of stocks and specified precise qualitative and quantitative rules for each category.

    Serenity Stocks shows how one can assess 5000+ NYSE and NASDAQ stocks by a complete 17-point Benjamin Graham assessment, with no adjustments other than those for inflation.

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  • April 3, 2015 at 1:33 pm

    While I buy the argument that ETF is better than Index tracking MF as it has a lower expense ratio, the Index is basically a list created by some people based on certain criteria (like market cap, sector, etc etc), isnt it. Correct me if I am wrong.

    So essentially its a formula. So why can’t we expect somebody to devise a better formula (instead of labelling them as actively managed mf).

    If you agree to this argument, then Actively managed Equity MF have a case.

  • April 3, 2015 at 4:43 pm

    Fair point Amit. In my view, a passive indexing strategy tries not to guess which stocks are best to invest in by investing in as much of the market as possible. Ideally, this would be the CNX500 or the BSE500 which are the 500 largest companies in India by market cap that account for about 96% (by market cap) of all publicly traded companies in India.

    An actively managed fund will have a fund manager guessing which sectors and stocks will do well and therefore switching in and out racking up transaction costs in addition to the cost of managing the fund. Add to that the process of identifying which fund to invest in, do you go with the fund with the best recent returns or some other criteria, and for the investor too busy to do his or her own analysis, passive indexing over the long term is a sustainable option.

  • May 4, 2016 at 8:41 pm

    Nifty is heavily biased towards financial sector. If active funds can avoid the laggard stocks of index then it’s easy to beat the index.

  • May 4, 2016 at 8:51 pm

    Why warren buffet advice index investing while he practices active fund management strategy? Investing is buying into stocks of real business managed by real people. So Investing decisions should involve human judgement and not some arcane formula.

  • May 6, 2016 at 1:22 pm

    Partha, human judgement is in fact the problem in most money decisions, due to the inherent biases we carry (are you more or less likely to buy on a day the NIFTY declines by 5%?) The objective of indexing is not to find the right stocks but to take human judgement out of the equation). But like the post says, it’s not for everybody.

What do you think?