Andrew Hallam is the index investor for Globe Investor's Strategy Lab. Follow his contributions here and view his model portfolio here.
When newspapers sponsor public challenges for active investors to strut their stuff, the results are often embarrassing. In 2012, the British paper The Observer pit selected professional stock pickers against a group of children and a cat named Orlando. The feline purred to the top, gaining 10.8 per cent, compared to 3.5 per cent for the professionals and a 2.9 per cent loss for the kids. (Orlando made his picks by throwing a toy mouse at a grid of numbers allocated to different companies.) How did Vanguard's British stock market index measure up? It gained 17.4 per cent.
In 1993, when The New York Times ran a contest pitting a group of high profile financial advisers against the S&P 500, the competition (which was meant to run 20 years) was cut short after just seven. The index crushed them all. And in 2002, the Financial Times reported a stock-picking battle between a five-year-old kid, an astrologer and a professional portfolio analyst. The winner was the child, beating the professional analyst by 52 per cent.
I'm pleased to write that my Strategy Lab colleagues John Heinzl, Norman Rothery and Chris Umiastowski aren't suffering such humiliation. In fact, they might be putting together the greatest stock-picking run ever publicized in a major newspaper. John's portfolio of rising dividend payers is up 10.38 per cent for the year (Sept. 13, 2012, to Sept. 30, 2013) and Norm and Chris are putting Warren Buffett to shame after gaining 32.78 per cent and 106 per cent respectively.
But can you beat the market from your laptop? Most stock pickers think so, or they wouldn't bother trying. But the majority would be better off with index funds.
Despite my colleagues' amazing performance over the past 12 months, only half of their 30 stocks beat the performance of Vanguard's total world stock market index, which gained 19.52 per cent to Oct. 1, 2013 (15.02 per cent in U.S. dollars). These are bright gentlemen. But one year ago, they had no idea which of their stocks would beat the market, lose to the market or by how much.
After a decade or more, we'll have a better idea how much luck went into their picks. With half of their stocks underperforming the global index over the past 12 months, their winning stocks could have been fuelled by a fortunate tailwind. Do I believe that John, Norm and Chris have stock picking ability? Yes, I believe they do. But beating the stock market is a heck of a lot tougher than running a marathon or completing an Ironman.
To some, that might sound nuts. But based on my lifelong experience as an endurance athlete, almost anyone with drive and discipline can complete a marathon or an Ironman. Not so with beating the market. Maintaining a long-term edge is more like winning an Olympic medal.
In the Stanford University published paper The Arithmetic of Active Management, Economic Nobel Prize-winner William Sharpe asserts that the typical actively managed dollar will underperform the market in direct proportion to the fees charged. If you believe that professional investors can beat the market by half a per cent before fees, it means the average amateur stock picker must underperform the market each year.
If you've beaten the market over the past five or 10 years, are you lucky or skilled? It's a question fund manager Bill Miller has asked himself. He outperformed the S&P 500 with his Legg Mason Value Trust fund for 15 straight years – an outright record. But in 2008, he got squashed. And his 15-year winning advantage over the market was completely erased over just two short years. In 2012, he resigned from running the fund.
When interviewed about the reasons for his fund's decline, he cited "bad decision making." He also admitted to shareholders, "There was, of course, a lot of luck involved in the streak."
Andrew Hallam