What if you could crack the secret code that beat the markets?
Don’t tell me you never imagined it. It’s every investor’s dream—a set of principles that would put you in the top 0.001% of investors worldwide.
I won’t lie to you. Consistently outperforming the benchmarks is damn hard. Only a handful of investors can lay claim to that honor.
But there are ways you can close the gap…and dramatically improve the returns you make on your money.
First, let’s take a look at the benchmarks themselves. The most widely watched stock market benchmark in the U.S. is the S&P 500.
Only a certain kind of stock gets into this illustrious index. Most people don’t know it, but the stocks that are listed on the S&P 500 are selected by a committee, who themselves are chosen by the owner of the index, Standard & Poor’s. Here are the specific criteria the committee uses:
- Liquidity – The committee chooses stocks that are highly liquid and easy to trade. (So, for instance, Warren Buffett’s Berkshire Hathaway isn’t part of the index because each share costs over $125,000. This makes Berkshire difficult to trade.)
- Recent profitability – The committee looks for “four quarters of positive net income on an operating basis.” Companies that aren’t profitable in the recent past don’t make the cut.
- Market capitalization – Each company must have a market capitalization (the sum value of all its outstanding shares) of over $4 billion.
- Representative of the economy – The committee tries to keep the index in line with the overall economy. So if the banking sector represents 20% of the overall economy, it should ideally represent the same percentage of the index.
This is actually a pretty good formula for success. The S&P 500 committee managed to beat over half of all active fund managers over the last 10 years—fund managers, I’ll add, that charge you money for this underperformance!
This means that you’d have had a 50-50 chance of beating half of all actively managed funds over the last decade by just buying a low cost ETF that tracks the S&P 500, such as the SPDR S&P 500 ETF (NYSE:SPY).
SPY has a super low expense ratio of just 0.9%. So, it’s pretty darn cheap. And pretty darn effective, too.
But say you wanted to beat the S&P 500. Are there any proven techniques for doing that?
As it happens, there are…
In his book More Than You Know: Finding Financial Wisdom in Unconventional Places, Legg Mason’s chief investment strategist, Michael Mauboussin, created a screen of the actively managed funds that beat the S&P 500 over the 10 years ending in 2006. He found that four characteristics set this group apart from the majority of actively managed funds. They were:
- Patience – The successful funds held stocks a lot longer than the unsuccessful ones. The successful funds had an average holding period of three years, versus one year for the average fund.
- Portfolio concentration – The outperformers tended to concentrate their bets on a smaller number of stocks. They had an average 35% of their assets in the top 10 holdings, versus 20% for the S&P 500.
- A value approach – The successful funds all had a value approach. They sought to buy stocks selling below fair value.
- Geographical location – Most of the successful funds were based far away from Wall Street. Instead they were based in places like Chicago, Baltimore and Memphis.
Now, I can’t ask you to move home if you happen to live in New York. (My own feeling is these investors did better than average because they were far away from the group-think of Wall Street.)
But it would be reasonable to expect you to pay attention to the first three criteria on the list, given that they are all key differentiators between beating the benchmarks and falling short of them.
Is your investing approach in line with these long-term winners? Are you a patient value investor with a manageable portfolio? If not, you may make money over the short term, but you are unlikely to succeed over the long haul.