Sometimes I wonder why everyone isn’t getting better returns than a simple Couch Potato portfolio. Spend a little time and you’ll discover all kinds of strategies that beat the market. And I’m not talking about the nutbars who promise 5400% gains on penny stocks—no one takes those seriously. I mean reasonable strategies that have been studied by academics—or at least serious practitioners.
Really, why would anyone use cap-weighted index funds when equal-weighted indexes, fundamental indexes and value-weighted indexes all crush them over the long run? And why buy the whole market instead of zeroing in on small-cap stocks, value stocks, and low-beta stocks, all of which have outperformed the broad indexes?
If you want to keep your volatility low and still pull in 9% a year, just put half your money in gold and cash with The Permanent Portfolio, which had just two negative years in the last 40.
Better still, pick the individual stocks that will deliver better risk-adjusted returns. Screening for high-yield had a great run in the US and also worked in Canada, China and Finland. Or just pick companies with a history of raising their dividends. Heck, even common sense works: just pick companies in essential industries.
If you want a colourful graph showing how these strategies kick traditional indexing to the curb, I can help you find one.
Of course, this leads to an important question: If there are at least a dozen simple ways to beat the market, how come so few investors are actually getting these returns? Obviously the costs and taxes involved in implementing these backtested strategies are a huge part of the problem—in fact, they’re enough to immediately render most of them useless. But let’s ignore that for argument’s sake. I suggest an equally large problem is the very mindset of the active investor.
Will you hold on when it’s not working?
By definition, active investors expect to beat the market. Most acknowledge they can never do this over every period, but their behaviour suggests they don’t have a lot of patience with underperformance of even two or three years. And there’s the rub: even if you accept there are legitimate market-beating strategies, all of them will see multi-year periods when they will lag. Even small-cap and value stocks—which probably will deliver higher-risk adjusted returns over periods of many decades—have endured prolonged stretches of dramatic underperformance. Some active investors have been rewarded for sticking to their strategy during rough stretches, but they are exceedingly rare.
Index investors are not immune to impatience, of course, and many have bailed on the strategy during periods of market turmoil. But I would argue the experienced ones have expectations that are quite different form those of the active investor. We know that when the markets go down 20%, we’re going to lose 20%—but never significantly more. When that happens, we don’t complain that the strategy is breaking down. Because delivering the same return as the market is exactly what indexing is supposed to do.
On the other hand, if beating the market is your primary goal, you’ll frequently wonder whether your strategy is working. In a year when markets are up 10% and you’re down 3%, you’re likely to be frustrated, even furious. When it happens three or four years in a row—and it will with even the best active strategies—most investors will have already switched to something else. Talk to a few advisors or look at mutual fund inflows and outflows if you don’t believe me.
I like to remind investors that the Couch Potato strategy isn’t just about low cost and broad diversification. It’s about accepting that the markets give what they give, and the best we can do is capture as much of that as possible. That means accepting that over any period three, or five, or even 10 years, there will always be investments that would have done better. But there won’t be a lot of investors who can make the same claim.