This post will fall on deaf ears, because, quite frankly, it is too sophisticated for most non-professional investors to understand. But it needs to be said. Long-term stock market investing is driven by the market more than your stock picks, and when you don’t know which stocks to buy (with some of your money), do NOT sit in cash, instead sit in a low-cost S&P 500 ETF. Your future bank account will thank you. Here is why…
Passive S&P 500 ETF Beats Most Active Investors
We hear all the time that passive S&P 500 ETFs outperform most active investors. But what we do not often hear is the real reason why. Sure, we get fake and/or partial reasons all the time, like:
Active stock pickers are too emotional, just buy the S&P 500 and take your emotions out of it.
Active investors charge high fees, just buy a low cost passive ETF instead (of course you can buy individual stocks instead, if you do it right, and pay zero fees (i.e. less than the 3 basis points on your S&P 500 ETF) and still perform better).
You don’t have the skill to buy individual stocks, just buy the whole market with an S&P 500 ETF (of course real investors know that the S&P 500 is NOT the whole market, it’s only about 85% of the publicly-traded US stock market).
But the real reasons stock pickers get beat by an S&P 500 ETF is because…
Stock pickers sit in cash too much: Overconfident stock pickers frequently sell their winners and then just hold cash until they find their next opportunity. This is a TERRIBLE idea. Instead, stay fully invested and if you cannot find any attractive stocks to buy then for goodness sake keep your long-term stock market exposure intact by owning a low-cost passive stock market ETF. It will eliminate that ridiculout cash drag that causes so many active investors to underperform over the long-term. Remember, just a small amount of underperformance each year leads to huge underperformance over the long term—yuck!
The S&P 500 is not actually passive it’s active. Although the changes are slow (i.e. a typically annual rebalancing) the S&P 500 index does change over time. Bad performing stocks get kicked out, and new up and comers (like Palantir) get added in. If you just randomly buy stocks, and never look at them again for the next few decades you will fail to weed out the horrible losers like the S&P 500 ETF does, and you will fail to add in the new up-and-comers like the S&P 500 does.
Stock pickers confuse “alpha” with “beta.” I see it every single market cycle. A new social media investor, or a new fund manager, gets a hot hand and attributes it to their great stock picking skills when in reality they just own high-volatility stocks that are highly sensitive to the stock market, and when the stock market is going up then the new investor (and all their followers) think is is because they are great stock pickers. In reality, it’s because they’ve assembled a high-beta portfolio. And as soon as the market turns south, the high beta leads to underperformance, the followers abandon ship, the portfolio manager gets fired and/or finds a new job, and the portfolio gets disassembled at the exact wrong time—ie. the bottom, and thereby underperformance gets locked in, and once again the “passive ETF” crowd says—see I told you so.
How to Beat the S&P 500 Over the Long-Term
Don’t pay unecessary high fees (unless you are getting something worthwhile for them, in which case they could be considered necessary). Fees come directly out of your bottom line. By assembling a prudently concentrated portfolio of attractive stocks you can avoid virtually all of the fees.
Don’t be overly passive. The S&P 500 ETF is not really passive (as described above) it’s just a really slow moving active strategy, and that’s how you should approach investing as a long-term stock investor. Just don’t over trade because you are gripped by fear or greed as so many people (both sophisticated and unsophisticated) often are.
Understand your beta exposure. Beta is a dynamic but highly-useful stock specific metric that can be aggregated (with diversification benefits) into a portfolio measurement. If your portfolio beta is consistently below 1.0 (i.e. the beta of the S&P 500 according to most standard practioners) then you are basically going to underperform the S&P 500 over the long-term because the market goes up over the long-term (a lot!) and investors with low beta go up with the market—just less! Similarly, if you are going to have a high beta then you can quite easily outperform the market over the long-term IF you occassionally prune out the big losers like the S&P 500 does, and IF you have the stomach to stick to your high-beta strategy when the market is down (because you will be down more). But over the long-term, prudently-adjusted, low-fee (or zero-fee) high-beta portfolios outperform the market, and they outperform by even more if you pick good stocks (but remember, the stock-picking component is just factually usually less of a contributing factor than your beta exposure in most cases of portfolio investing). Worth mentioning, low beta is the reason most dividend strategies underperform over the long-term, and failure to prudently periodically prune your big losers is the reason most high-beta strategies underpeform over the long-term. Remember, its the economy that drives the stock market higher over the long-term, and you want to own stocks that benefit, over the long term, from a growing economy.
Stay fully invested for the long term, as described.
The Bottom Line
If you follow the “how to’s” described above, you can outperform the S&P 500 over the long-term, and if you are into that type of thing it is very enjoyable (I say that from experience). Just remember (in addition to the things described above) if you don’t have any good stock ideas at a particuar time—you’re better off parking the money in an S&P 500 index fund (like tickers VOO or SPY) instead of in cash (which will be a long-term negative drag on your returns that compounds over time—yuck!). And we can save the discussion about home country bias and small-cap-versus large cap weights (including the current uniqueness of the Magnificent 7) for another day.
Be smart people. Do what is right for you.
*ps. I know this post will mostly fall on deaf ears, but if you are serious about maximizing your returns subject to your own risk parameters (to retire earlier and/or leave more money to your spouse, kids and grand kids) pay attention to the contents of this post because it’s worth a lot of money.