The recently published In Pursuit of the Perfect Portfolio, by Andrew Lo and Stephen Foerster, reviews the work of 10 of the most prominent academics in the world of investing, including six Nobel laureates. They are asked to describe the investment portfolio most likely to produce the highest return combined with relatively low volatility.
Although each of these experts has a slightly different view, there is strong agreement on one point. They are unanimous that, over the long run and after fees, active investors in an efficient stock market will not be able to beat an ultra-low-fee index fund or index exchange-traded fund.
Because broad index fund products typically have less turnover (buying and selling of stocks) than actively managed portfolios, they also tend to trigger lower capital gains tax. Consequently, index products can be even more attractive on an after-tax basis – and may beat those who avoid paying a fee by making their own investment decisions.
This reality, surprising to many, has been confirmed by numerous objective studies. It is a point often made by Warren Buffett.
The most common retort by professional investors is to simply deny that it is true. To quote Upton Sinclair, “It is difficult to get a man to understand something when his salary depends upon his not understanding it.”
And it isn’t just professional investors who don’t want to hear this message. Most individual investors believe they are well above average; they resent the suggestion that their investing activities add no value.
So, does this mean that you would be better off simply investing your money in an index product?
Undoubtedly, some people would be. But there is another inconvenient truth at play here. For more than 30 years, independent investment research firm Dalbar has compared the investment return of funds and investors in those same funds. Over time, the average investor dramatically underperforms the fund in which they are invested. For example, over the 30-year period ended Dec. 31, 2021, the S&P 500 index had an annual return of 10.7 per cent whereas investors who bought funds tracking the S&P 500 had a return of only 7.1 per cent. Fees account for far less than half the difference.
How can this be? The great investor, Benjamin Graham, once said, “The investor’s chief problem – and even his worst enemy – is likely to be himself.” Emotions cause people to buy when prices are rising, and sell whenever the market price falls. Buying high and selling low has never been a formula for investment success.
Although there is no way to prove this, the tendency to panic may be less for those invested in companies. If you own TD Bank, Microsoft and Walt Disney Co., and know something about those businesses, you will understand why the economic value of those companies is likely to increase over time – with the stock price eventually to follow. Whereas, if you own an index product, it is harder to think about anything other than the price. Owning a fund may make it more likely that you will react to the volatility of the market, rather than focusing on economic fundamentals.
There are also tax planning advantages to owning individual companies. For example, if you need to sell shares to raise money, you can elect to sell those with the lowest unrealized capital gains. You can’t do this if you own a fund.
The key for individual investors who choose to own individual companies is to find a reasonable number of profitable and growing businesses, in different sectors and geographies, that appear likely to prosper for decades to come. If you have the discipline to maintain your ownership of these companies over time, you will own a basket of assets that is likely to grow, for many years to come, far faster than the rate of inflation. You will also defer the payment of capital gains tax.
The authors of In Pursuit of the Perfect Portfolio conclude that “The pursuit of the Perfect Portfolio is the foundation of financial liberty – the freedom to reach your financial goals and all the happiness it may bring.” For some, this may be achieved by owning an index fund. For others, owning a portfolio of proven companies, held for the long run, will be the road to success.
R.B. (Biff) Matthews is the chairman of Longview Asset Management, an investment management firm based in Toronto.
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