The Third Pig

Source: Flickr by timcullen

At the extremes, the bottoms of bear markets and the tops of bull markets, you will undoubtedly hear that buy and hold is dead. We find ourselves in the former market (we hope) thus that old refrain has returned. Over the last 10 year, the S&P 500 has seen a -2.5% annual yield (ending 4/30). Those who become disenchanted with the buy and hold strategy are folks generally uncomfortable with what feels like doing nothing. Alternatively they set to a course of frenetic trading at what seem to be opportune times. Unfortunately this approach leads to very little except frustrated investors.

The Journal of Finance published a white paper by two Cal Berkeley professors, Brad Barber and Terrence Odean which chronicled the folly of the active trading approach. Right from the abstract of the paper they write:

Of 66,465 households with accounts at a large discount broker during 1991 to 1996, those that trade most earn an annual return of 11.4 percent, while the market returns 17.9 percent. The average household earns an annual return of 16.4 percent, tilts its common stock investment toward high-beta, small, value stocks, and turns over 75 percent of its portfolio annually. Overconfidence can explain high trading levels and the resulting poor performance of individual investors.

So how does an investor beat the market?

Relax: The first thing to do is to simply take a chill pill. Most of what you need to beat the market comes down to your temperment. If you can keep a cool head while all the world is losing theirs you will have a tremendous advantage. Fear and panic cause investors to make bad decisions more often than not. So stay cool.

Stop trading: Transactions costs, the least of which is commission, eat away at returns. As damaging is the bid-ask spread as well as the capital gains taxes paid on any small gains made. According to Barber and Odean:

The investment experience of individual investors is remarkably similar to the investment experience of mutual funds. As do individual investors, the average mutual fund underperforms a simple market index. Mutual funds trade often and their trading hurts performance. But trading by individual investors is even more deleterious to performance because individuals execute small trades and face higher proportional commission costs than mutual funds.

Control your emotions and your ego: Consistently beating the market is difficult. For this very reason it pays to take your emotions and your ego out of it. Do you really think you will create some investment approach that is somehow smarter and more fantastical than the methods used by Warren Buffett or John Templeton? It's foolhardy to chase the latest fad in investing (or to think you'll create it) when the tried and true works like a charm.

Hold just a few positions: The investor would do well to select only the stocks of companies he understands well. By doing so he will reduce his portfolio's risk by steering clear of permanently weak companies and avoiding overpriced firms, not by excessive diversification. Increasing portfolio positions past 20 to 30 positions does very little to reduce volatility any further. Interestingly though, increasing positions past this point will continue to reduce returns. According to mutual fund manager Robert Hagstrom, concentrated portfolios of 15 securities are 13 times more likely to outperform the market than portfolios of 250 securities. In other words, excessive diversification fails to effectively reduce volatility risk yet greatly handicaps the investor’s ability of beating the market.

Buy at the right price: Even the greatest company will not make a good investment if it is overpriced. Determining the correct price for an investment is difficult as it requires many assumptions. But it is essential to a sound investment process. If bought at a price below the company's real value, all an investor really needs to do is wait until the price of the stock reflects the true value of the company. Eventually, it will.

If an investor follows these few steps, he can relax on the beach and let others worry about the ups and downs of their portfolios.

Disclosure: none