August 26, 2006 –
Are you tired of always hearing that the smartest way to invest money in the stock market is to buy an index fund when you know that other people consistently beat the S&P 500 and other major index funds of other global stock markets? Everyday, I see articles online by people with all these fancy letters next to their name – PhDs, MBAs, and CFPs – who claim that they’ve conducted numerous studies to prove that you just can’t beat the major global stock market indexes.
As an insider at two of the largest financial firms in the U.S. for seven years, I know that this is a bunch of bull. Most of the things I consistently read about stock investing in the major media are just not true. People merely chew, regurgitate and spit out the same things they’ve heard in the past because they sound good without ever taking the time to truly dig down the rabbit hole to discover if there is really any truth to them.
So let’s closely examine and deconstruct three popular “givens” of online investment articles. Since there are more studies online about the U.S. market S&P 500 index than any other major global index, we’ll take a look at this index.
Most U.S. investment advisors discuss the S&P 500 as the benchmark index against which to rate performance.
Sure, the S&P 500 comprises about 80% of the entire market capitalization of U.S. stocks, but even though many U.S. investment advisors seem to live in some strange time warp that discounts the value of global stocks, we very much live in a global economy today. The U.S. only accounts for 25% of total global output today, and more than 75% of publicly traded companies reside outside of the United States (Source: Forbes Online, February 2006). Therefore, when companies exist in Brazil, Mexico, China, Canada, the U.K., Germany, France, India and Japan that can significantly boost the performance of a stock portfolio, it is extremely short-sighted to rate the performance of any portfolio against the performance of the S&P 500 index.
Furthermore on average, no matter what country a financial advisor lives in, most advisors allocate only about 6% of their clients’ portfolios to foreign stocks. That’s just a ridiculous stat. With the majority of publicly traded stocks residing on exchanges outside of your country no matter what country you live in, how can only 6% of your portfolio be invested in foreign stocks?
The fact that 90% of U.S. mutual fund managers underperform the S&P 500 is often stated as proof that the S&P 500 is extremely hard to outperform.
Even if you added back all the fees U.S. mutual fund managers charge, even if this percentage was as high as 5% a year, it would not change the fact that the returns of U.S. mutual fund managers are not blowing the performance of the S&P 500 out of the water. This still doesn’t mean it’s a great feat if managers beat the index as so many investment advisors lead you to believe. Invest in the global market and the S&P 500 isn’t become that hard to beat anymore.
What makes it so hard for old school money managers at large investment firms to beat the S&P 500 is that in-depth analysis of promising global stocks is often lacking, even at the major Wall Street firms. I would estimate, on a purely anecdotal basis (from having scoured the research database at many large investment houses), that 80% of the global stocks that interest me do not show up on the major firms’ lists of researched stocks at the price points I am interested in. This simply is due to the fact that most huge investment firms do not provide much coverage of small and micro cap stocks. It is only after some of these stocks appreciate 50%-100% that the big firms will sit up, take notice, and finally start to initiate coverage.
Because the returns of an actively changing S&P 500 over a 10-year, 20-year or 35-year period are sometimes more or less equal to a static S&P 500, this is often stated as conclusive proof that active management of a stock portfolio is an exercise in futility.
I’ve seen many studies that claim some variation of the above study. For example, someone will perform a study and say if you look at the companies that comprised the S&P 500 in 1970 and kept a portfolio of those exact 500 companies until 2000, your returns would more or less have been the same as if you owned the dynamic S&P 500 index (the actual S&P 500 index that de-lists and adds a handful of different companies every year) over that same time period. Then that person will conclude “active management doesn’t help you all that much”.
If you consider my first two points, this piece of advice is an illogical, ludicrous piece of advice that is used to cover up the inability of advisors to add value to their clients through active management of their stock portfolios. One can only draw such a flawed conclusion by assuming that one’s stock portfolio should contain no stocks of companies located outside the United States. If this is the case, then okay, I’m willing to concede that this argument.
In summary, realize that many arguments for index funds and a focus on U.S. stocks are deeply flawed. Ever hear of the argument “the greater the perspectives, the better the solution”? In stock investing, if you insist on tying your performance to your country’s major stock index and refuse to embrace a global stock portfolio, then you are already falling behind from the moment you start.
There is a warrior saying: “You fight like you train.” The problem why so much bull exists in the investment world is you gotta look at the trainers. Who’s training these advisors and consultants to fight your battles in the investment world? And what are the trainers training the trainees to do? To maximize profits for the firm or to be the best investment advisors possible? Do you think the maximum amount of time in training investment consutlants is spent on sales techniques or investment analysis? I don’t even have to be an insider like my partner to know the answer to that one.
Until next time, Be a rock standing in the ocean.
Thanks JKIM