Beating the market – You don’t have to swing for the fences

I’ve recently started re-reading the long collection of memos from the chairman of Oaktree Capital, Howard Marks. I didn’t get very far (halfway through the first memo from 1990) before reading something so important that I had to turn it into this editorial.

I’ll leave it to a pension fund manager, who Marks quotes in his memo, to make the point. The pension has a long-term track record way ahead of the S&P 500:

“We have never had a year below the 47th percentile over that period or, until 1990, above the 27th percentile. As a result, we are in the fourth percentile for the fourteen year period as a whole.”

So the fund managed top results over 14 years whilst never having a single outstanding year in that time. This example shows that an investment approach based on “swinging for the fences” is just not necessary.

Many investors who move from index tracking to stock-picking in an effort to do better end up trying to beat the market every year, and by a wide margin at that. Every stock they pick has to look like it will produce 20%, 30% or even more in a single year.

It’s that endless attempt to find the big winners which can cause so much trouble. What people don’t realise is that beating the market by a huge margin in the long-term only requires a small advantage on an annualised basis and definitely doesn’t require you to beat the market every year.

For example, if you start out with £100,000 and invest at an inflation-adjusted rate of 5% annualised, which is about what the FTSE 100 gets in the long-term, then you’ll have gained the inflation-adjusted equivalent of about £165,000 in 20 years. Re-run those 20 years at a rate of 8% (just 3% above the market average), and you’ll have gained the equivalent of about £366,000, or more than twice as much.

So imagine a portfolio which gets 1% more than the market from dividends by owning high-yield stocks; then it gets another 1% more than the market by owning higher (but not necessarily high) growth stocks; and finally, by owning stocks with low price to earnings ratios, it gets another 1% as those valuation ratios revert upwards towards their historic mean.

That doesn’t sound impossible, does it?