Trying to Outperform the Market

Portfolio Management
July 16, 2023

The primary decision for many wealthy families is whether to invest in indices or try to outperform the indices by investing in individual stocks. The answer to this question drives what type of advisory fees you’re going to pay, how much your tax bill will be and most importantly, what type of investment advisor you’ll need.

Our portfolio consists of 90% individual stocks, so we’re not against this strategy, but it’s certainly not for everyone. We’ll point out the issues with individual stock investing so you can make an intelligent decision as to whether it’s right for you.

There are very few investment strategies that outperform the S&P every year. Renaissance Technologies Medallion Fund has had world-beating returns. The link below provides the details.

Unfortunately, Renaissance Technologies does not need you as an investor. The fund is only open to select employees of the firm. They offer other funds, but as you may have guessed, the returns of those funds are far less spectacular.

The strategies that have been able to outperform the market over long periods of time offer inconsistent annual returns. As Warren Buffet says regarding annual returns, he’d rather have a lumpy 15% than a smooth 12%. Sounds great in theory, but when your portfolio has a 20% loss in the same year as the S&P 500 has a 10% gain, many people dump the lumpy strategy, especially if the underperformance lasts a few years.

Joel Greenblatt, one of the most successful investors of all time, started a mutual fund using some of his strategies. The fund’s portfolio consisted of 50% stocks selected by his strategy and 50% replicating the S&P 500. When I saw this, I was confused. Why would you have an actively managed fund run by one of the most successful investors in the history of investing dilute his strategy by having half the portfolio replicate the S&P?

I saw Greenblatt interviewed and he explained that most investors can’t tolerate wide variances of returns from the index. If a fund was down 10% while the index was up 10%, they’d sell it. He decided to sacrifice some of the potential outperformance to reduce the variance from the index, also known as tracking error.

If you want to outperform the market, you have to be able to tolerate multiple periods where you underperform the indices, sometimes by significant margins. If you’re not programmed for that, stick with the indices.

Our strategy focuses on investing in a subset of the S&P Dividend Aristocrats universe. These are companies that have raised their dividends every year for at least 25 years. We eliminate those with high debt, high dividend payout ratios, and some other metrics that are part of our secret sauce. The goal of this strategy is to slightly underperform or match the market’s performance on the way up and outperform during a crisis. During the crisis, we sell stocks in our portfolio that have held up well and use those funds to buy stocks that have been, in our opinion, oversold. An example of this is from the pandemic: Walmart, a dividend Aristocrat held up well; Exxon, another dividend Aristocrat dropped from $60 to $32.

We’re not suggesting you use this strategy; we’re just giving an example of a strategy we’re confident in and are able to stick with through periods of underperformance. If you’re going to invest in individual stocks, it helps to understand exactly what your strategy is and why (through rigorous testing) you’re confident it can outperform the index.

A financial advisor is great for helping you establish your goals and setting up and sticking to a plan to achieve them. If a financial advisor could outperform the S&P 500 consistently by 2%+, they’d be running a hedge fund. If you read our article on the tax implications of turnover, you’ll see that in a taxable account, you’ll have to outperform by more than 2% to offset Uncle Sam’s cut.