One Way to Beat the Market

A couple weeks ago I looked at John Maynard Keynes’s investment performance and philosophy when he ran the endowment fund at King’s College. Keynes ran a focused portfolio made up of a small number of stocks. One of the results of holding a small numbers of holdings was that his performance numbers were very volatile, something that led me to conclude he would probably be fired as an investment manager today because of professional investor’s aversion to volatility.

This is one of the conundrums of outperforming the market – to outperform you have to be different than the market.  But to be different than the market that means excepting a wider range of potential outcomes.

How wide are these potential outcomes you might ask?

Portfolio manager and author Robert Hagstrom performed a study that looked at 12,000 randomly generated portfolios from a universe of 1,200 stocks. He broke the portfolio up by the number of holdings so they looked as follows:

• 3,000 portfolios containing 250 stocks.
• 3,000 portfolios containing 100 stocks.
• 3,000 portfolios containing 50 stocks.
• 3,000 portfolios containing 15 stocks.

Next, Hagstrom looked at 18 years of performance data for each portfolio from 1979 to 1996. This period included the extraordinary bull market of the 1980s and 1990s so the annual returns for the S&P 500 were 15.2%. Now take a look at the range of returns by portfolio holding size:

• For 250-stock portfolios, the best return was 16.0% and the worst was 11.4%.
• For 100-stock portfolios, the best return was 18.3% and the worst was 10.0%.
• For 50-stock portfolios, the best return was 19.1% and the worst was 8.6%.
• For 15-stock portfolios, the best return was 26.6% and the worst was 4.4%.

A portfolio with many holdings in it has a higher probability of performing closer to the market average in a tighter range. This is one of the benefits of diversification. A focused portfolio gives you a much higher chance of doing much better than the market, but also a much higher chance of doing much worse than the market. This is the nature or risk and return. If it was easy, everyone would be doing it.

Now take a look at the outperformance rates by portfolio size:

• Out of 3,000 250-stock portfolios, 63 beat the market (2% of portfolios).
• Out of 3,000 100-stock portfolios, 337 beat the market (11% of portfolios).
• Out of 3,000 50-stock portfolios, 549 beat the market (18% of portfolios).
• Out of 3,000 15-stock portfolios, 808 beat the market (27% of portfolios).

You can see that as the number of holdings decreases, the number that outperform increases. This makes sense because the greater number of holdings you have in a portfolio, the more likely it is that it will look and act just like the market. Many active mutual funds are closet index funds because they hold so many stocks with similar industry weightings to the market (which is also why they underperform after their high fees).

To beat the market, you have to be different than the market. And to meaningfully beat the market, you have to be meaningfully different than the market. The large tracking error is something most investors cannot stomach. But there are those investors that are constantly seeking ways to beat the tar off the ball and destroy the market. Most investors can’t handle the normal swings in price in the overall market, so it’s really about knowing yourself and what you can handle.

An alternative for those investors that want to have the option of beating the market while still controlling risk and tracking error is to spread your portfolio between a broad-based index fund with no tracking error and putting the rest in a high tracking error fund. This would equate to something of a barbell approach.

It all depends on the amount of risk you’re willing and able to accept as an investor. But for those that would like to beat the market, it’s clear that a focused portfolio gives you better odds, although you also have better odds of severely underperforming.

As they say, “You pays your money and you takes your chances.”

Source:
The Warren Buffett Portfolio

Further Reading:
Feast or Famine in the Fairholme Fund