Benchmarks, aka Index Funds

How to use them to beat the market:

If you are an investor there are two possibilities:

Possibility Number 1

You are outperforming the benchmarks described herein, either absolutely or on a risk adjusted basis. If you are outperforming, then you deserve to be congratulated. You may continue doing whatever you were doing, secure in the knowledge that your efforts are adding value to appropriate benchmarks.

Possibility Number 2

You are NOT outperforming these simple benchmarks. If not, then you may wish to examine your current strategy because the two strategies described below are easy to implement, they are tax efficient, they have ultra low expenses, and they have reasonably sustainable performance.

The Strategies

These are a long term strategies, meaning the longer the term, the better they will work.

What do I mean by long term?

The short answer is a minimum of ten years, because a ten year period will generally include a bear market and a bull market, but longer is better.

I'll be using ten years of performance history throughout this paper. The last ten years have not been kind to US investors, so the BIG question is: Will the NEXT ten years be a repeat of the last ten years, OR will it be "Happy Days are here again? Regardless, these strategies work reasonably well during the good times AND during the bad times.

First I'll write about a US only strategy.

After that I'll write about global investing.

Before I get started, I'd like to take a few minutes to review three definitions that will help you understand this paper.

NEGATIVE CORRELATION

If one asset in a portfolio gains value when another loses value then the assets are negatively correlated. A portfolio containing negatively correlated assets is highly desirable because you could sell the assets that rose in value in order to acquire money to buy the assets that fell in value. US Bonds and Stocks have been negatively correlated since the late 1970s and they will probably continue to be negatively correlated until there is a massive change in global monetary policy.

REBALANCING the PORTFOLIO

If a portfolio contained 50% Stocks and 50% Bonds at the beginning of a period, and if it contained 51% Stocks and 49% Bonds at the end of the period then it could be rebalanced by selling 1% of the portfolio's stock to purchase more bonds. This would rebalance the portfolio to its original allocation.

RISK ADJUSTED RETURN

Equal returns are sometimes NOT equal. For example, over the ten year period ending December 2007, US Stocks and US Bonds had almost equal returns. However, stock returns were far more variable than bond returns, so even though the absolute returns were more or less equal, the risk adjusted returns were not. Risk adjusted returns can be precisely quantified, but I'm not going to get into any detail because a reasonable explanation is beyond the scope of this paper. Just remember that the risk of an asset increases as the variability of its return increases. If you want to learn more about risk adjusted returns then simply search the internet for "risk adjusted returns". If you spend a few hours acquiring some knowledge then you will know more than most professional financial advisors.

***************************************************************************************

Many investors believe they have the ability to predict the future. Perhaps not precisely, but many honestly believe that their intuition will tell them where and how to invest, and many honestly believe they have a "sense" or a "good idea" where the market is heading in the near or far future.

Do YOU believe your intuition can tell you where and how to invest?

Did your intuition tell you where and how to invest ten years ago?

Hold those thoughts.

Most investors are confused, and many spend their investing lives moving from one inappropriate investing idea to another. From January 1984 through December 2003, during the greatest bull market the United States has ever seen, the S&P 500 had an average annual return of 12.98%. During that same twenty-year period the average investor in a stock mutual fund earned 3.51%.

Dalbar, in Boston, revealed this in a 2004 paper titled “Quantitative Analysis of Investor Behavior”. If you want the full report then here is a link that will give it to you. Dalbar Analysis

You may be asking yourselves how it is possible for the average mutual fund investor to trail the index by such huge margins. Good question!

There is a simple explanation: Most mutual fund investors will purchase a mutual fund only if they are reasonably certain that they are buying a winner. The most common method of determining a winner is to examine a five or ten year track record. The problem is that this method is almost guaranteed to produce a loser: Here’s why:

Yesterday’s winner is probably NOT going to be tomorrow’s winner.

Here’s what happens to the typical mutual fund investor:

Step 1. Purchase a “winning” fund

Step 2. Patiently wait an average of three or four years for it to outperform

Step 3. Sell it in disgust

Step 4. Buy another “winner”

Step 5. Repeat steps 2 thru 4 over and over again

The fact is that you have a better chance of picking a winning horse at a racetrack than you do of picking a winning mutual fund, simply because horses have reasonably reliable track records.

One of the most important lessons to be taught and learned is that it is virtually impossible to beat an appropriate index on a risk-adjusted basis.

Some of you may not agree, but you should be aware of the fact that a mountain of academic and empirical evidence supports that statement.

That does NOT mean a benchmark can’t be beaten, but it does mean that it is extremely difficult. It also means the outperformers generally cannot be identified before the fact.

In spite of all that, I am now going to tell you,

How to beat the market:

Here are two simple rules.

Follow them, and you will beat the market.

Ignore them, and the market will beat you.

Buy Low

Sell High

You already knew that, right?

But how many of you have a strategy that will help you do exactly that?

How many of you even have a strategy?

I know, beyond any reasonable doubt, that the typical investor does NOT have a strategy. I can also tell you, with reasonable certainty that you will NOT “invest happily ever after” if you invest without a strategy.

What else does it take to beat the market?

Mark Hulbert, the editor of the Hulbert Financial Digest, has been monitoring financial newsletters for more than twenty-five years. His conclusion is that almost any reasonable strategy will beat the market yet only about twenty percent of the letters he monitors beat the market.

How is that possible?

If almost any strategy will beat the market then why does the market beat so many investors?

According to Hulbert, there are three magic factors you need to beat the market: Discipline, Discipline, and more Discipline

I will give you two Strategies.

The Discipline to implement a Strategy is up to you.

I am going to start with a simple two asset US only Portfolio

Asset 1     The Total US Stock Market Index

Asset 2     The Intermediate Term US Bond Index

Both Indices can be bought as Mutual Funds or Exchange Traded Funds

Over the ten years ending with December 2007 the US Stock Market, including dividends and distributions, had an annualized return of 6.25%. That return may come as a surprise, because it is substantially lower than the ten or twelve percent average return Wall Street likes to brag about.

Over that same period, US Bonds had an annual return of 6.32%. That means that over the last ten years, US bonds returned MORE than US stocks.

That's not what we thought we were gonna get when the “experts” told us stocks return more than bonds.

The BIG question is:

What's gonna return more over the NEXT ten years: US Stocks or US Bonds?

Most experts will AGAIN tell you that stocks are gonna return more than bonds but remember: They weren’t exactly right ten years ago and they have a pretty good chance of being wrong now.

Why? Simply because nobody has the ability to predict the future.

So: How much in stock? And, how much in bonds?

There are many ways of answering those questions. Determining a "proper" bond-stock allocation is beyond the scope of this page. Go to another page on this website for a more comprehensive explanation: Stock and Bond Ratios

Instead, let us simply assume that a careful examination of our resources has convinced us to invest 50% in bonds and 50% in stock.

Let’s examine a chart showing the quarterly returns of the two-asset US Portfolio over the ten year period ending last year.

The chart shows that buying and holding US Stocks would have yielded slightly less than buying and holding the US Bonds.

The chart also shows that the bond portfolio increases more or less steadily, while the stock portfolio bounces up and down like a yoyo. That means that stocks are far more risky than bonds.

Regardless, if you had bought and held equal amounts of each, then your average annual return would have been the simple average return of the two components.

What would your return have been if you had re-balanced the portfolio to its original 50% bond and stock allocation at the end of each quarter?

Your return would have been GREATER than the average return.

I’m going to repeat that, because it is highly counter-intuitive.

If you had re-balanced the two asset portfolio at the end of each quarter then your return would have been GREATER than the average.

Let’s take a look at a chart of the two-asset portfolio with a new re-balanced curve.

Notice that a third curve has been added to the chart. This is the return one would have realized if the two-asset portfolio had been rebalanced at the end of each quarter.

Rebalancing a portfolio regularly accomplishes several important goals:

1. It reduces variability

2. Purchases are made when the market is low: Buy low

3. Sales are made when the market is high: Sell high

Once again, this is a long term strategy, meaning the longer the term, the better it will work. It also means there will be some short periods during which it will not work.

For example, during the nineties a portfolio consisting exclusively of US Large Cap Stocks would have outperformed. But, as we all know now, a Large Cap Stock portfolio would not have worked too well during the period we just went thru in this new century. Indeed, during the ten year period that ended with March of 2008, the bond portfolio DOUBLED the return of the stock portfolio.

This is a chart of the same portfolio, but this is for the ten year period ending March 31, 2008. During this ten year period, bonds outperformed stocks, both absolutely and on a risk adjusted basis.

That is highly unusual. However, the return of the portfolio was greater than the average return of its components AND it had about half the variability of the stock portfolio.

This simple model will outperform about 80% of all actively managed US portfolios for two important reasons:

1. The expenses are close to zero. That means that you avoid paying most management fees and trading costs. Expenses have an enormous negative impact on a portfolio over long periods.

2. IF, and this is a BIG IF, you have the discipline to implement this strategy, you will be buying low and selling high.

It does not get much better than the model I just described.

That is unfortunate, because even though the return of the portfolio was greater than the return of either of its components, it was still only 6.83% per year for the ten year period ending December 2007.

That is NOT what most of us were hoping for when Wall Street cheerleaders told us to invest our hard earned money in the stock market. 

However, now that the US stock market has under-performed almost every other stock market over the last ten years, we are being urged to "think globally".

Strategy Number 2: Global Investing

Among American financial planners and commentators, it is almost universally accepted that shares always rise over the long run. This perception is backed by the evidence: During any twenty-year period, Wall Street has always delivered positive returns.

But the United States may have been a special exception. A study conducted at the London Business School examined the record of sixteen global stock markets. China and Russia were excluded, because their stock markets were not in continuous operation during the last century.

The paper, titled “Irrational Optimism” showed that only three other countries could match the American record of having no twenty-year periods with negative real returns.

Since 1900, the worldwide inflation adjusted return on stocks averaged close to five percent per year. However, Japanese, French, German, and Spanish investors all suffered periods where they had to wait more than 50 years to earn a positive real return. In Italy and Belgium the waiting period stretched to 70 years.

There is another problem with the belief that stock markets must always go up: The very existence of the belief is likely to lead to its falsification. Investors will keep buying until prices reach stratospheric levels. That clearly happened in Japan in the 1980s, and with the tech heavy NASDAQ in the 1990s.

After hearing all these dismal facts, you could easily assume that I am opposed to stock ownership in general and foreign investing in particular. But you would be wrong.

The major stock asset classes of the world are:

US Large Cap Stocks

The US Extended Market (The US Extended Market includes all US stocks smaller than Large Caps i.e., Mid Caps, Small Caps, Micro Caps, etc.)

Developed Europe

The Developed Pacific

And Emerging Markets

Over the ten years ending with March 2008, the best performing stock asset class was Emerging Markets, which returned about 13% per year.

The worst stock asset class was US large caps, which returned less than 3.5% per year. That's incredible: Ten years, at less than 3-1/2 % per year.

At the beginning of this paper you were asked the following questions:

1. Do YOU believe your intuition can tell you where and how to invest?

2. Did your intuition tell you where and how to invest ten years ago?

You were asked to hold those thoughts.

Let’s go back ten years to early 1998. Ten years ago, many investors believed that they had foreseen the wonderful performance of the US market and the disappointing performance of Emerging markets.

Hindsight bias gave investors the confidence that they could forecast the next successful markets and the next disasters. Can you accept the fact that your market timing abilities are nothing more than the illusion of hindsight bias? Can you accept the fact that beating and timing markets is difficult at best?

You know more than most if you can accept those facts. If you do not believe them, then try to learn the limits of your foresight. Record your forecasts as you make them and check their accuracy.

By now you should have realized that I do not believe anyone can predict the future. I hope you believe that too.

If you do NOT believe that, then here’s a little test for you: Write down your forecast. It is extremely important to write it down because, “The palest ink is better than the best memory.” I discovered that in a Chinese fortune cookie about twenty years ago, and I never forgot it.

If you don’t want to wait ten years to find out how good your forecast was then make a three month forecast, or even a three day forecast. It won’t take too long for you to recognize the wisdom of John Kenneth Galbraith who said: "The only function of economic forecasts is to make astrologers look respectable".

How can this information be used?

You probably remember that earlier I combined the Total US Stock Market and the US Intermediate Term Bond Index. We saw that combining assets that do not always rise and fall together will increase the return of the portfolio. This is a well known phenomenon.

And that is one very good reason to add foreign stocks to your portfolio. Unfortunately, it is also a bad reason to add foreign stocks to your portfolio.

Why?

The red line on the chart represents ten years of the S&P 500. Ten years ago the US dollar was supreme and emerging markets were crashing. The black line represents emerging markets. In 1998, emerging markets were called SUB merging markets. At that time, they were a bargain, but stock market bargains are NOT considered desirable assets.

In 1998, most Americans believed we were the only honest and industrious people in the world, and that our virtue would be rewarded if we invested our money in US large cap stocks.

If you are a typical human then you are xenophobic. That means that you have an unreasonable fear, or even hatred, of foreigners or strangers. To some degree, we are all xenophobic. It is that part of our DNA that enabled our ancestors to survive. Unfortunately, it also enables us to enthusiastically look forward to killing one another.

Now that almost every other stock market in the world has outperformed US large caps for more than ten years, many US investors have forgotten their fear of foreign investing.

The question, of course is: What will it take to re-awaken our collective xenophobia, and how will you respond when there is a xenophobia epidemic?

If you add foreign stocks to your portfolio because careful research has convinced you that foreign stocks are a desirable component of any portfolio then it is probably a good idea.

However, if you are choosing this point in time, to add foreign stocks to your portfolio because they have outperformed lately, and you believe that the outperformance will continue in the foreseeable future then it is probably a mistake.

Why? Because when they crash, and they WILL crash, you are gonna say, "I knew that was gonna happen." And you are probably gonna sell your foreign stocks. And that is exactly the wrong thing to do.

The bottom line is that if you sell your foreign stocks after they crash, then you are NOT going to do well as an international investor. In fact, if you sell ANY stock market after it has crashed, then you are not going to be a successful investor. Peter Lynch, the legendary manager of the Fidelity Magellan Fund said this a long time ago: "Stock markets sometimes decline. If you do not understand that is going to happen then you will not do well in the stock market".

The following Asset Allocation Models have been posted on the Asset Allocation page of this website

Shown above are two sets of ten year returns for the S&P 500, the US Strategy, and the Global Strategy. Once again, Wall Street cheerleaders are fond of telling investors that the annual return of the S&P 500 is ten, or twelve, or even fourteen percent.

The annual return of the S&P 500 for the ten year period ending March 31, 2008 was 3.4%. That's the return that was reported by Vanguard, and it includes dividends and distributions. The last ten years have not been good to US stock investors.

The US Stock and Bond Portfolio returned considerably more than the S&P 500, AND this return was realized with considerably less variability.

The Global Model returned over thirty percent more than the US portfolio over the last ten years, but remember: Global portfolios do NOT always out-perform US portfolios.

Quarterly rebalancing added about ten percent to each portfolio.

The stock and bond proportions shown above represent what I call neutral allocations. Obviously the proportions can be changed to create more or less aggressive portfolios.

I prefer the global portfolio because almost forty years of my data show a higher risk adjusted return for global investing. To be sure, there are several well known problems with international investing. It is reasonably well known that most folks are xenophobic. Generally, the intensity of the phobia is inversely proportional to the financial sophistication of the investor, but there are many notable exceptions. The second problem is that most investors will feel reasonably good about international investing when the international indices out-perform their home indices, but some will feel like fools, and some will feel like traitors, when the home markets out-perform. Because of this reasonably well known phenomenon, they are likely to abandon international markets at the worst possible time.

Why have I chosen to equally weight the stock classes?

Any investment has an equal chance of out or under-performing any other investment on a risk adjusted basis so when you overweight one relative to the other you are betting that one will out perform the other. Examine the major (or minor) asset classes of the world. Which one(s) is(are) going to return more during the next year or the next decade? Who knows? Not you and certainly not I. Let's face it: Nobody knows, so why should you worry about under or over-weighting your resources?

Having written that, I will also write that there are probably many good reasons for over or under-weighting asset classes in a portfolio. Many investors decide to keep 85% of their stock portfolio in the US, which over-weights the US considerably. Do they have a good reason? Rightly or wrongly they are betting the US has a much, much greater chance of out-performing the rest of the world. Time will tell if they have made the right decision, but history is not on their side.

I do not want to leave you with the impression that the asset allocation model described above will always outperform everything over any ten year period, because it probably won't. The chart below shows that emerging markets outperformed all the other major stock asset classes. The chart also shows that the red stock and bond portfolio outperformed everything else, AND, it did it with about HALF the variability of a stock portfolio. It does not get much better than that.

I have introduced two fairly simple index oriented benchmarks that will outperform about 80% of all actively managed stock & bond portfolios. Once again, these are long term strategies, meaning the longer the term, the better they will work. One important reason these indexed portfolios work so well is simply because the expenses are much lower than managed portfolios.

Some of you are probably outperforming these portfolios, either absolutely or on a risk adjusted basis. If you are outperforming, then you deserve to be congratulated. You may continue doing whatever you were doing, secure in the knowledge that your efforts are adding value to appropriate benchmarks.

However, if you have not been outperforming these simple benchmarks then you may wish to examine your current strategy.

If more complex portfolios appeal to you then here is some good news. There is considerable evidence that substituting several asset classes for one asset class will add value. For example, substituting growth and value components for an appropriate index would have added value.

There is also considerable evidence that adding other asset classes will add value to a portfolio. For example, over the last ten years, a commodities or a precious metals component would have added considerable value. A REIT, also known as a Real Estate Investment Trust would also have added considerable value.

It is fairly easy to add asset classes that would have added value when you have the benefit of hindsight, but there are also many asset classes that would have subtracted value during the last ten years. The technology sector is one of them. At this point in life, most of us know that an attempt to improve something does not always result in an improvement.

Be careful, and remember the KISS principle. In 2004 there were more than 55,000 Mutual Funds in the World, and that does not include any of the Hedge Funds that are multiplying like rabbits. In 2004 there were more than 8,000 Hedge Funds in the US. Almost every fund is an attempt to improve the performance of an index. About 80% of them have failed or will fail. Some of them will fail miserably. The easy way to be a successful investor is to avoid failure. The easy way to avoid failure is to avoid actively managed funds.

Try to remember the two factors that are necessary for investment success:

1. You need a Strategy - preferably a written Strategy.

2. You need Discipline to maintain the Strategy.

Here are the immortal words of Jesse Livermore:

“The market does not beat investors. They beat themselves.”

Jesse Livermore was famous for making large amounts of money and then losing it. He was reputedly worth $100 million at the end of 1929.

On March 28, 1933, the 56 year old Livermore married the 38 year old Harriet Metz Noble. It was Harriet's fifth marriage, and all four of her previous husbands had committed suicide.

I wish I could tell you the Jesse Livermore story ended happily, but, alas, I cannot. Spend a few minutes on the web and investigate the "Jesse Livermore" story. You won't regret learning a little more about this fascinating investor, and, of course, his one true love.

Both the portfolios discussed herein are posted on the Asset Allocation page of this website. They are rebalanced quarterly and the quarterly performance data are shown for each asset class. You may wish to compare your own performance with these models.

Let me know if you're beating them. If you are, then I will tell you everything I know about the financial newsletter business. Perhaps we can start a new newsletter. I have found that financial newsletters can be fun, and sometimes even profitable.

Over the past ten years I have issued that challenge to innumerable amateur and professional investors. Very few accepted my challenge, and so far, only one has survived for more than five years. Go to WEIMERandWIRTH Performance History for the details

I used ten years of Stock and Bond performance history herein to "make my case". Note that the last ten years have been atypical because US bonds outperformed US stocks. I was asked what the results would have been if I had used a longer period. That is a very good question. I can tell you that there was indeed an equity premium during the past several hundred years, but in my opinion, this premium may not exist in the future, and if there is an equity premium in the future then it may not be as great as it was in the past. Here's why:

1. Monetary policy now is a lot different from monetary policy before Alan took over. Thanks to the "Maestro", global monetary policy now aggressively creates liquidity during any economic crisis. That almost guarantees a negative correlation between stocks and bonds. That's not the way things were during the earlier periods. Global monetary policy may change again in the future, but I do not believe it will happen "anytime soon". Note that this does not really explain a disappearing equity premium, but it makes a powerful case for periodic rebalancing.

2. I believe bonds are much more efficiently priced now, and this does explain a disappearing equity premium, but that's an opinion.

3. I believe stocks are much more efficiently priced now too. I also believe stocks are very optimistically priced relative to most periods before 1980 or so, and especially before Merrill Lynch paid the University of Chicago Graduate School of Business to tout stocks. I believe they will continue to be "priced for perfection" until there is a massive change in the way financial commentators and analysts perceive risk. This, too, is an opinion to explain a disappearing equity premium, but there is considerable information available to substantiate that opinion.

Please note that the models I presented may not beat everything in absolute terms in the future, and they may not even beat everything in risk adjusted terms. However, any asset class that beats these models is going to have to beat them over long, long periods. A single asset class can outperform for short periods, but the chance of outperformance diminishes with time. Many studies verify that statement.

The bottom line is that there will probably always be something that outperforms the models herein. In order to identify that "something" before the fact, you must have the ability to predict the future. I predict that WEIMERandWIRTH will outperform, but I am not as sure of my prediction as I once was.

Revised May 20, 2008

Return to Home Page