Are you tired of always hearing that the smartest way to invest money in the stock market is to buy an index fund when you know that other people consistently beat the S&P 500? So am I. And I’m here to try to finally put this argument to rest.
Everyday, I see articles online by people with all these fancy letters next to their name – PhDs, MBAs, and CFPs – who claim that they’ve conducted numerous studies to prove that you just can’t beat the S&P 500. Well I have a degree in Neurobiology from one of the top 5 schools in the United States as well as a Master in Public Affairs from a top 5 masters program, and Master in Business Administration with a concentration in finance from a top 15 business school, and I’m here to tell you that all that education hardly gives me any advantage at being a better stock picker than the next person.
What does give me an advantage is forward thinking, progressive thinking and thinking differently. In fact, I decided to write this article simply because I grew weary of reading things about stock investing that just are not true. Everyday, I encounter a wide array of online articles from old-school, self-proclaimed investment gurus that tell you it’s impossible to beat the S&P 500. This is a claim that arises out of thinking that is mired in the stagnant investment strategies that seem to be so deeply entrenched in every large investment firm. So let’s closely examine and deconstruct three popular “givens” of online investment articles.
Most U.S. investment advisors discuss the S&P 500 as the benchmark index against which to rate performance.
Sure, the S&P 500 comprises about 80% of the entire market capitalization of U.S. stocks, but even though many U.S. investment advisors seem to live in some strange time warp that discounts the value of global stocks, we very much live in a global economy today. The U.S. only accounts for 25% of total global output today, and more than 75% of publicly traded companies reside outside of the United States (Source: Forbes Online, February 2006). When companies exist in Brazil, Mexico, China, Canada, the U.K., Germany, France, India and Japan that can significantly boost the performance of a stock portfolio, it is extremely short-sighted to focus primarily on U.S. stocks, and the performance of the S&P 500 index for your target returns.
The fact that 90% of U.S. mutual fund managers underperform the S&P 500 is often stated as proof that the S&P 500 is extremely hard to outperform.
Even if you added back all the fees U.S. mutual fund managers charge, even if this percentage was as high as 5% a year, it would not change the fact that the returns of U.S. mutual fund managers are not blowing the performance of the S&P 500 out of the water. This still doesn’t mean it’s a great feat if managers beat the index as so many investment advisors lead you to believe. Invest in the global market and the S&P 500 isn’t that hard to beat anymore. It may be time consuming, but certainly not so difficult that beating the index should be viewed as an “incredible” feat when it happens.
What makes it so hard for old school money managers at large investment firms to beat the S&P 500 is that in-depth analysis of promising global stocks is often lacking, even at the major Wall Street firms. I would estimate, on a purely anecdotal basis (from having scoured the research database at many large investment houses), that 80% of the global stocks that interest me do not show up on the firms list of researched stocks at the price points I am looking to buy in. This simply is due to the fact that most huge investment firms do not provide much coverage of small and micro cap stocks. It is only after some of these stocks appreciate 50%-100% that the big firms will sit up, take notice, and finally start to initiate coverage.
And even then, sometimes the analysis is still lacking depth or meaningful analysis. As I spend most of my time in Asia now, when I look at big firms’ analyst coverage of Chinese, Korean, or Japanese stocks, many times they do not cover half of the points I consider to be important, including analysis of how the political and legislative environments potentially affect the growth prospects of companies.
Because the returns of an actively changing S&P 500 over a 10 year, 20 year or 35 year period are sometimes more or less equal to a static S&P 500, this is often stated as conclusive proof that active management of a stock portfolio is an exercise in futility.
I’ve seen many studies that claim some variation of the above study. For example, someone will perform a study and say if you look at the companies that comprised the S&P 500 in 1970 and kept a portfolio of those exact 500 companies until 2000, your returns would more or less have been the same as if you owned the dynamic S&P 500 index (the actual S&P 500 index that de-lists and adds a handful of different companies every year) over that same time period. Then that person will conclude “active management doesn’t help you all that much”. If you consider my first two points, this piece of advice is an illogical, ludicrous piece of advice that is used to cover up the inability of advisors to add value to their clients through active management of their stock portfolios.
One can only draw such a flawed conclusion by assuming that one’s stock portfolio should contain no stocks of companies located outside the United States. If this is the case, then okay, I’m willing to concede that this argument put forth by many U.S. investment advisors may hold some water. But currently I’m tracking ten global stocks that I’m quite confident will beat the S&P 500’s performance in FY 2006, and I don’t even own these stocks! Why? Because I own other foreign stocks that I believe will offer even better performance this year.
In summary, realize that many arguments for index funds and a focus on U.S. stocks are deeply flawed. Ever hear of the argument “the greater the perspectives, the better the solution”? In stock investing, if you insist on tying your performance to the S&P 500 and refuse to embrace a global stock portfolio, then you are already falling behind from the moment you start.