The Struggles of Investing With Funds

Jason Zweig recently wrote a post on how relatively easy it is for amateur investors to beat the pros (Wall Street Journal, April 14, 2023 https://www.wsj.com/articles/active-vs-passive-index-fund-beat-the-stock-market-58e8bd83). I couldn't agree more. But as I've written before, I also think amateurs can beat the indexes, although it's considerably more work.

Here's some of what Mr. Zweig says, with my thoughts.

Essentially, Mr. Zweig points to the handicaps fund managers work under, handicaps that, according to a recent 30-year study of thousands of U.S. stock mutual funds, results in most funds underperforming the market.

The first problem is their insidious fees. I used this word deliberately. According to the Online Etymology Dictionary, it comes from a Latin word insidiae meaning “ambush, snare, plot,” which is derived from the Proto-Indo-European term sed, “to sit,” usually with a suggestion of lying in wait with the intent to entrap. This is fitting, as “insidious” often carries the meanings “deceitful,” “stealthy” or “harmful in an imperceptible fashion.”

This is just how fees work in the financial world. Generally speaking, financial instruments are far better at finding ways to get more money out of you than they are at managing your money. And I do mean “far better.”

Today's online world has an abundance of low-cost offerings that with their low fees offer you a significant advantage over an actively managed fund. Unfortunately, this is not where financial firms guide your investments, simply because they make a lot less from these offerings. It’s a sort of bait-and-switch tactic.

There are many indexed funds charging 0.03% to own most of the U.S. stock market. This is not 3 percent, not 3 tenths of a percent, but 3 hundredths of a percent, about $30 a year in fees on a $100,000 investment. The typical actively managed fund charges over 1%, or $1000 a year on this same investment, 33 times more than you can easily find online. And many funds charge significantly more than the 1%.

The typical fund analyzed in this study returned 7.7% a year after fees. However, the funds’ investors earned only 6.9% annually because of the compulsion of clients to chase hot performance and to sell when things go bad. This is your classic buy high, sell low problem where you should instead do just the opposite: buy low and sell high.

For the fund managers, though, they are forced to buy high priced stocks with the flood of money that comes in from investors chasing high returns, and in reverse, are then forced to sell stocks when they are low to generate the cash needed for their investors who are selling out of their fund when prices drop. Mr. Zweig states it well that "the managers can perform only as well as their worst investors allow them to." And that is not a good return.

The total cost to the fund that is forced to buy high and sell low is nearly as high as the drag from annual fees. What do these actively managed funds cost investors? From 1991-2020, investors lost about $1.02 trillion dollars, money they could have saved if they had instead bought a low-cost index fund tracking the S&P 500.

Mr. Zweig then repeats a supposed axiom of market returns, and that is "in the long run, nearly all the market's return comes from a remarkably small number of stocks—giant winners that rise in value by 10,000% or more over decades."

He cites other research that shows that only 4.3% of stocks created all the net gains in the U.S. market between 1926 and 2016. This suggests that winning requires finding these very few stocks, and this is mostly a matter of luck. Which then gets you back to buying indexes that mostly ensure you get at least some of these gains.

I've never accepted the argument that very few stocks are good investments. First, almost no one buys stocks and holds them forever. So what an individual stock does over a lifetime is of little interest to most. I have all my stock transactions for over two decades available to search and analyze. I have not found it to be true that a very small proportion of my stocks have created most of my gains. I grant you that I also haven’t owned thousands of stocks so my example may be a poor one.

Yes, it's true that there's usually one hot stock for any given period that brings in a lot of my returns. But when I measure longer time periods, the number of stocks that bring in most of my returns gets quite large. I've drilled further into my stocks. When I eliminate the one or two best stocks and the one or two worst stocks (that is, the extremes), I find that the middle ground returns about the same as the edges. And this holds as I eliminate more of the extremes.

I did a quick test on Mr. Zweig's claim. I downloaded performance data from the largest 500 stocks as of April 24, 2023, which roughly approaches the S&P 500, and calculated their total return (gains, losses and dividends) for the prior 12 months. The stocks had lost about 5.6% of their total value in the prior 12 months.

However, the average stock lost only 2.6% during this same period, and the middle 50 stocks lost 4.6%. So the most middling stocks did slightly better than the entire index, and the average stock did 3 percentage points better than the entire index. This hardly suggests that over a defined period of time, such as one year, one needs to find a very few hot stocks to keep up with the indexes, and in fact, in this one look into a random 12 month period, the middle and average stocks both outperformed the index.

What I am saying from this simple test is that it doesn't matter if Apple or Tesla or Amazon or even Exxon-Mobile bring in an outsized lifetime return. I'm not buying stocks for a lifetime. I'm owning them up to several years, and I have no evidence that I need good luck to keep up with the indexes. I can buy average stocks and do quite well.

Indexes by their nature buy high and sell low. By their design, their simplicity, by their very nature they function well. Yes, they perform better than almost any actively managed fund—which is well documented—but not great.

I'm fairly convinced that an individual with a basic understanding of finance and math, with the emotional ability to see beyond the past year or two, and to accept some occasional deep drops such as we had in 2022, by owning several dozen stocks can beat the indexes—both with lower fees and with better returns. And they can do this by avoiding overpriced stocks that the indexes (and everyone else) love, that in the end do not do as well as perceived.

Mr. Zweig gives some additional good help for investors that want to try their luck with individual stocks. Avoid big, household-name companies and avoid following crowds into the latest meme stock.

He suggests that investors instead look for winners among smaller firms with good financials. Limit yourself to a handful of possibilities and don’t put more than a total of 5% of your money in them. Further, never add new money to a winner. This will help you win well when you’re right, and will limit your losses when you’re wrong.

And if you do find a winner, hold it as long as you can. Small potential fortunes are lost selling after a stock doubles or triples, watching on the sidelines while it continues to double and triple still again. By then, of course, you’ve lost this opportunity.

Against common advice, I’ve kept about 30% of my equities in individual stocks and the rest in low-cost indexed funds. Since the market peak before the Great Recession to today, which includes two bear markets, my individual stocks have performed significantly better than my index funds. The gains seems to be quite widespread, and not because of a couple of lucky purchases.

My additional suggestions with individual stocks is to be slow to buy and slow to sell, regardless of where their price is going. Keep an eye on the stock’s fundamentals: margins, debt and dividends. And don’t be afraid to check out an annual or 10-K report. If something smells bad, it may be time to sell it.

Although I generally recommend indexes over individual stocks, for someone who is willing to put time into stock research, there are a lot of fees to be avoided and a lot of money to be made following some basics with individual stocks. As my analysis on the S&P 500 shows, using a dartboard to buy a dozen stocks from the S&P 500 will probably outperform the S&P 500. And this is probably because you’re passing on overpriced stocks that are overallocated both by individuals and indexes.