The Path Is Clear, The Walk Is Hard (Part 1)

Yet, it’s hard to beat the market. Most who try fail.

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The Market Is Hard (But Not Impossible) to Beat

When friends and family with limited investment expertise ask me how they should invest, I tell them to stick to low-cost total market index funds. That may seem like a naïve approach. After all, there are plenty of people who make uninformed investment decisions and many smart investment managers who attempt to take advantage of them.

Yet, it’s hard to beat the market. Most who try fail. Everyone’s looking for high-return, low-risk invest­ments. When they arise, money tends to come flooding in, driving up prices and cutting future returns to a level proportionate with their risk. As a result of stiff competition among investors with diverse perspectives, market prices tend to do a good job reflecting publicly available information. This makes it difficult to carve a durable edge. While inves­tors aren’t perfect, many of the mistakes they make are uncorrelated. This makes the whole better than the sum of its parts over the long term.

But the market is far from perfect. There are shared biases, created by common cognitive errors and emotions like fear and greed that can create systemic mispricing. These biases likely contributed to the historical success of factor investing and will probably continue to do so. Institutional frictions can also create mispricing, particularly in the bond market. For example, many investment-grade bond fund managers are forced to sell their holdings when they are downgraded to below-investment-grade, which can cause them to become undervalued.

However, even if you can identify pockets of mispriced securities, it can take a long time to profit from that insight. There’s always a chance that mispricing could increase. A small edge, which is usually all investors can realistically hope for, is often overshadowed by volatility. This can cause even the best strategies to underperform for years. Investors who do anything other than invest in broad market index funds should be willing to accept long stretches of underperfor­mance. It’s a question of when that will happen, not if.

Factors Are Promising, But Do Your Homework

Based on the research I’ve seen and done, factor investing offers the most promising way to beat the market, as these strategies take advantage of systemic mispricing or risks that the market rewards. Yet there’s often a gap between these funds’ portfolio construction and the factors documented in the academic literature they purport to harness. Funds that target the same factors often look and perform quite differently from one another, increasing investors’ due-diligence burden.

There are a lot of choices out there, but the best are backed by strong economic intuition, effectively harness well-vetted factors (like value, momentum, quality, and low volatility), diversify risk, and safe­guard against unintended bets.

Don’t Lose Sight of the Portfolio

It’s easy to focus on the merits of each individual holding in a portfolio and ignore how they work together. But that interaction is just as important, as bets in one fund might be offset by opposing bets in another. Take care to avoid reconstructing the market portfolio with high-cost funds that don’t complement each other.

The diversification benefits of each fund should be considered in the context of the portfolio. For example, adding a high-yield bond fund may seem to improve diversification by expanding into a new market segment. Yet such a move can have the oppo­site effect because those bonds carry greater credit risk than investment-grade bonds, and the payoff to that risk is positively correlated with stocks’ performance.

Look Beyond Yield

Just as it’s prudent to view a portfolio holistically, it’s best to consider income investments holistically, too. Yield doesn’t tell the whole story of any invest­ment. Aggressively chasing it often introduces consid­erable risk and can hurt total returns. In the bond market, that relationship is fairly obvious. Higher-yielding bonds tend to carry greater credit risk (and often other types of risk).

While broadly diversified dividend strategies often carry less risk than the market, unusually high divi­dend yields tend to be a sign of trouble. Stocks get there either by paying out a large share of their earnings as dividends, leaving a small buffer to cushion those payments should earnings fall, or by trading at unusually low valuations, reflecting weak or deteriorating fundamentals. Usually, it’s a combination of the two.

In part 2 of this article, we will continue to discuss how to look beyond yield.

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