The increased market volatility since October 2018 is a source of investor concern. People see news stories about losses and rebounds, making them look more closely at their own portfolio. Is it winning a race with the Dow? That is a good question, but a misleading one.
The Long-Term Investor is Not in a Race
If you are a long-term investor, your portfolio should reflect your personal needs and goals, risk tolerance, and market conditions. There are many reasons why you should not be “beating the market.” Here are some of the most important.
- You are emphasizing safety and accepting slow growth. This approach will only win the race when there is a market crash.
- You are emphasizing income. A good income portfolio delivers the expected yield on time and grows with inflation to meet your needs. The underlying holdings vary widely in value, especially in a general market decline. You should not care, as long as the stocks are sound.
Your growth program emphasizes superior long-term results. This means being different from the overall market. You can do this in various ways, including these two.
- Choosing stocks that are trading below their fair value and holding them until reasonable price targets are achieved.
- Trying to outguess what the market favorite will be – and doing this repeatedly for many years.
Beating the Market
Long-term portfolio outperformance has almost nothing to do with short-term results. In fact, the best choices for the future – whether stocks, sectors, or funds-- are frequently those that have not enjoyed recent success. It is all about popularity and sentiment. Investors and fund managers alike engage in chasing a popular theme.
Most investors greatly underestimate “long term.” Perverse market conditions can persist for several years, and sometimes longer.
Background on the Current Market
The new highs in market averages are deceptive. They are featured on financial news, but the index make-up is becoming narrower – much narrower. The top ten stocks now make up over 21% of the entire S&P 500. The top fifty account for half of the market. Here is a dramatic illustration.
Other popular choices are bonds and bond substitutes. These represent excessive fear and the false security of yield.
The implication? The best-performing stocks and sectors are over-valued and unattractive to those who ask the fundamental question -- what is the company worth?
Who are the current winners?
Most investment managers no longer attempt to realize superior returns. They choose a portfolio that meets a theoretical definition of diversification – even when some of the sectors they buy are greatly overpriced.
There are the individuals who claim success. They guy you meet at a cocktail party, a spouse, or maybe even your own account. If these people can do it, it should be easy. Or even worse – some guy on financial TV who has something to sell!
Simply put, anyone who has beaten the market in recent times has over weighted FAANG (Facebook, Amazon, Apple, Netflix, and Google) and maybe utilities. This has been a good guess about market sentiment, but it has nothing to do with the fundamental value of the companies. It has worked for a time, helped by a decade without a recession.
Eventually, most investors who venture out into their own stock picking world run into changing sentiment, a rough patch, or something even worse.
A key challenge to investors is to recognize when they have been lucky. Most do the opposite, an expensive choice. They project their success in their business or in a past guess about the markets to validate their wisdom about future investments.
What about index funds?
Many people choose the alternative of index funds. They are not planning to win a race against the market – just match it. This approach is better than some, but far from the best. Here are three important reasons.
- There is no effort to control risk. A strong portfolio is not merely “buy and hold.” Yes, that beats trying to time the market, but it unnecessarily takes excessive risks.
- Index funds are loaded with over-priced stocks. This is also true of most ETFs. When past laggards become the leaders, the picture will look much different.
- There is significant turnover in leadership – at least three of the top ten in the S&P 500 are replaced every five years. Wouldn’t you rather own the new leaders instead of the old ones?
Winning the market race commands attention, but the interpretation can be challenging and counterintuitive.
If your portfolio is beating the market, you have made a lucky decision to overweight certain stocks and sectors. Declare victory. Sell or seriously trim over-valued positions and look for cheaper stocks.
If your portfolio is not beating the market, it might not be a signal of danger. Take a closer look at your holdings. Do they make sense? Does the overall portfolio fit your goals?
Most solid, well-planned, and balanced portfolios are not beating the market. And that should not be your litmus test.
There are many good long-term ideas – stocks that are attractive using strong criteria:
- Strong earnings expectations
- Solid balance sheets
- Attractive valuations compared to the current price
- Wide moat and good business model
- Dependable management
These are not necessarily the current popular names, so you won’t see them featured in the news. You need to look for unloved stocks and dig deep into fundamental data.