“The goal of the advisor shouldn’t be to beat the market by picking stocks or winning funds. Advisors add value by providing the discipline required for successful investing. They add value in areas like tax efficiency, risk management, estate planning and retirement planning.” – John Bogle
Investors on Wall Street are obsessed with beating the market. And usually when we talk about “the market” it means the S&P 500. The S&P 500 is simply a stock market index weighted by market capitalization of 500 of the largest publicly traded companies.
Based on historical active mutual fund performance, beating this simple index can prove to be quite difficult. According to the latest S&P SPIVA Scorecard report, over 80% of large cap funds failed to beat the S&P 500 in the past 5 years. Over longer time frames, the numbers get even worse.
The easy solution here would be to invest in the Vanguard 500 index fund (VFINX) and pay ridiculously low fees to basically equal the performance of the S&P 500.
But is another way to beat the 500 index fund over the long-term…simply invest in the Vanguard Total Stock Market Index Fund (VTSMX).
While the S&P 500 index fund holds only large companies, the total stock market fund holds small and medium sized companies as well.
Historically, there has been a premium on small and mid cap stocks over their larger brethren. Currently, VTSMX has about 72% in large caps, 19% in mid caps and 9% in small caps.
Here are the performance numbers for these two funds going back to 1992 when the fund was started through October 31, 2013:
The total market fund outperformed the 500 fund in 13 of the 22 years or about 60% of the time. The outperformance isn’t huge, at 0.20% per year, but if you started in 1992 with $50,000 invested in each fund you would have almost $14,000 more in the total market fund by 2013.
These funds are cyclical, so there can be long periods of time when one fund or the other looks better on a relative basis. Here are the returns broken down into the two longest cycles:
Investors went bonkers for large cap stocks in the 1990s so they outperformed small and mid caps stocks. But since 2000 the trend has reversed and small and mid caps have led the outperformance of the total market fund.
It’s difficult to tell when these trends will end but you could make the case that small and mid cap stocks are getting pricey when compared to large cap stocks at the moment.
But over very long time frames, the riskier small and mid cap stocks have historically added to performance (see Why Diversification Works).
The point of this exercise is not necessarily that you should choose between either of these two funds for investment purposes (although you could do much worse than simply holding these funds for the long haul).
The point is that you should be skeptical when a financial advisor or investment manager claims to consistently “beat the market.”
You need to make sure they are benchmarking your performance correctly instead of just showing you your results against a single index that could have a very different make-up than your actual portfolio.
Adding smaller companies as well as value stocks has been shown to increase stock returns historically, but they could also increase the risk of your portfolio. Your results are not only a factor of your returns, but also of the amount of risk you take.
I think benchmarking is important to make sure you aren’t overpaying for sub par investment advice, but it shouldn’t be the only way you measure your portfolio.
Most advisors and wealth managers assume it’s their job to beat certain benchmarks to prove their worth. They would have more success if they focused on achieving the goals of their clients instead of consistently trying to measure themselves against the market.
The focus should be on lowering costs, ignoring short-term noise in the markets, thinking long-term and emphasizing process over outcomes.
If the goal is only to beat the market (outcome) you can lose sight of your overall goals (process).