The magic formula to beat the market? Don’t try. Babysit instead!!

Original photo created by Andreas Poike 

 

The title of this post may seem a little strange. Isn’t it the investor’s goals and dreams to beat the market? Everyone wants to pick those hot stocks which are going to fly. Everyone wants to make their portfolio outperform the wider market. Everyone wants to become the next “investing hero”, to be the next Buffett! Everyone wants to beat the market.

When I first starting investing, this was my goal: to beat the market. I was committed to achieving it. I gave up a lot of time to picking individual stocks. I thoroughly researched companies’ balance sheets, profit statements and cash flows. I followed a “watch list” in the media and read reports on every company I was interested in.

I tried to determine when was the best time to invest in the stock market. I spent time trying to work out whether to invest in developed markets, or whether I could find better returns by investing in emerging markets. Do stocks consistently outperform bonds? Is the Santa rally a real thing?

I spent weeks researching old data trying to determine if timing the market was possible.

I analysed PEs, PEGs, ROIs, EVs, NPVs, F1s, F4s and another million abbreviated investment terms and ideas.

I used all the skills I had developed as a chartered accountant to analyse companies. I was putting my hard earned skills to use!

After I had done all of this, I picked what I thought was the best company. On 27^th August 2008, with all the caution, fear and worry in the world, I put my £1000 into my first share.

I then started saving up for my next stock purchase. Rinse and repeat. I would need to do all of the above again. But this time, I would need to do all the research on the new stock, whilst making sure that none of the fundamentals of my original purchase had changed.

 

What is the problem with this?

Where do I start?!

One problem is clearly the lack of diversification.

£1000 isn’t a lot of money in terms of the market. However, for me at the time, it was huge. I’d scrimped and saved and now all of it was resting on the fate of one single company. All I needed was the CEO to be a crack-addict and I’d lost all my money (it happens)!

I was hopefully undiversified. However, I had a plan to buy a different company in a few months once I’d saved my next £1000 and that would help.

The problem is that it would take me months to be diversified. Research has shown that with a diversified portfolio in the S&P 500, even a portfolio of 100 stocks will deviate from the index by an average of 1.13% per month.

Therefore, 100 stocks would not necessarily constitute a diversified portfolio.

Some people argue that diversification to this level isn’t necessary and 20 stocks will be enough. So, if I manage to save up another £1000 every 3 months and invest this in a well thought out stock, it would take me 5 years to be sufficiently diversified.

Can you beat the market?

Ok, so you are diversified to a level where you have the freedom to beat the market, but sufficiently protected against risk. There is still a MUCH more significant factor in beating the market. Do you have the ability to do it?

The short answer is no, you don’t. Why am I so mean? Putting you down like that?

Well, let’s have a look at some facts.

1)      Traders can’t beat the market

Research by Brad Barber of UC Davis and Terrance Odean of UC Berkeley found that only about 1% of active traders outperformed the market. The more frequently people trade, the worse they do.

2)      Professionals can’t beat the market

In 2012, the mid-year S&P Indices Versus Active Funds Scorecard (SPIVA) shows that, with few exceptions, index funds have dominated their actively managed counterparts. In the 2012 year, the S&P Composite 1500 beat 90% of all actively managed domestic stock funds in the UK. Over the earlier three and five years, those numbers were 73% and 68%, respectively.

 

If the professionals cannot be the market, it is unlikely that you can beat the market.

 

Do you even really want to beat the market?

I didn’t actually write this article to put you down and say that you can never succeed in being the next Warren Buffett. Maybe you are extremely talented and you have the ability to beat the market.

However, even if this is the case, you should be asking yourself a certain questions. Yes, you can beat the market? But, do you WANT to beat the market?

What a stupid question, right? Of course you want to beat the market. Improving your return is essential to long-term wealth. That is what Moneystepper is all about, right?

Well, not necessarily. The secret sauce to improving your net wealth is…improving your net wealth. Improving your investment return is one way to do that. However, it may not be the most efficient.

 

The average investor

I actually found it quite difficult to find how much the average person in the UK or US has invested in the stock market. However, I am going to assume that, outside of a retirement fund, it would be less than £20,000 per person.

Let’s assume that the average person has £20,000 (outside of a retirement fund) invested: 20 companies with an equal investment of £1000 per company.

If you select these companies brilliantly, how much can you beat the market by?

According to morningstar.co.uk, there are around 672 UK Large-Cap Blend Equity funds registered in the UK, which are run by professionals whose job it is to beat the market. It is their job, their career, their life.

Let’s say that you, as an individual performing a good amount of research, find yourself some great performing stocks from the FTSE 100, which sees you finish in the top 100 of these funds. This means that you have beaten 85% of all professional fund managers. I repeat, you have beaten 85% of people who spend all day, every day as a professional trying to achieve this goal!

In this instance, you would have seen a return (including dividends) for the year to the end of February 2014 of around 22%. The FTSE 250 has gained by 20.4% over the same period. We shall also assume that your trading costs were nothing and that your bid-spread losses were nothing (good luck with that)!

By these figures, you can beat the market by 8% (difference between 22% and 20.4%). Assuming that the usual annual increase of the market (without dividends) is around 6%, then you, as a market beater, would be earning around 6.5%. I think this is what most people are aiming for when they are trying to “beat the market”.

 

What is beating the market by 0.5% worth?

This is the problem. 0.5% may seem like a big gain and that you have done incredibly well to do it. Well, you have. This is the point.

However, if you are the average investor with only £20,000 to invest, that 0.5% is equivalent to £100 per year.

Now, I’m not knocking earning an extra £100 each year. We should all try to do it. However, what I am concerned about is the work that we had to put in to earn that £100.

I would estimate that, before my first investment, picking that first stock for investment took hundreds of hours. I read text books, investing books, autobiographies and newspaper articles on investing and money for years before I even started to think about the individual stock.

Then, I looked at around 10-15 companies that I selected through a stock-screener (which took me about an hour alone), and then spent at least another hour analyzing each company.

For arguments sake, we can ignore all the original investment education and reading as a sunk cost. Let’s imagine that it was “fun”!!

Let’s also imagine that I’ve become so efficient in my research that I can earn 0.5% above the market by only researching 10 stocks each time I buy a stock, and only research each company for 30 minutes.

I then spend 30 minutes each week analyzing my overall portfolio and the markets.

For my portfolio of 20 stocks, this would take 5 hours for each stock I select (100 hours in total) and another 26 hours monitoring my portfolio.

Therefore, I earned approximately 80p per hour for my additional effort.

Yes, that’s right, beating the market for the average investor could be worth as little as 80p per hour!

 

Spend your time earning additional income

Why spend so much effort doing this? If someone offered you a job for 2 hours a week, but only gave you 80p per hour, I’m pretty sure I know where you would tell them to stick it!

Alternatively, you could spend 126 hours a year babysitting at £8 per hour. This would lead to an annual income of £1000, or ten times what you would get by “beating the market”.

Finally, I’ve explained the title of this post. Babysitting, for the average investor, is much more lucrative than beating the market.

Furthermore, whilst you are babysitting, you can catch up on something else which will help your long-term career and help your longer term wealth.

 

Stop wasting time trying to beat the market

If you are beating the market by 0.5% (which a very, very small percentage of individual investors will be doing), then you would need over £200k invested to make all the hours spend on research and monitoring to make it worthwhile.

If you’ve got less than £200k invested, just buy low-fee ETFs tracking the major indices. If you do want more advice over what indices to track, there is a good review of Nutmeg over at The Money Principle which you might find interesting.

Overall, I’m pretty confident that if you don’t try to beat the market, you will find better ways to earn additional income and generally better ways to spend your time!!