 of  Harry  M.  Markowitz  changed  the  way  investment  man-agers think, when he demonstrated that including certain classes of assetsin a portfolio influenced not only the profit potential of that portfolio, butalso its volatility, or the rate at which the value of a portfolio fluctuates.5The major conclusion of MPT that concerns our discussion is how to con-struct  an  investment  portfolio  that  aims  for  higher  profits  with  reducedrisk.
Markowitz did the original work in this field, and others have made sig-nificant contributions.6 Among those are Professors Sharpe, Cootner andFama.7 A  good  discussion  of  MPT  can  be  found  in  the  text  authored  byRudd and Clasing.8 The theory is not some obscure topic of interest only toacademics, but is widely used in today’s investment universe. Markowitzand Sharpe shared the Nobel Prize in economics in 1990 for their contribu-tions to this field.9
The early development of MPT relied heavily on statistics, and the pio-neering work is highly technical. Nevertheless, the basics of MPT can be ex-plained  in  simple  terms  (the  more  complex  math  remains  available  forthose readers interested in such details10). The discussion here is limited toexplaining what MPT is, why it’s important for today’s investor to under-stand its basic teachings, and how you can easily build a portfolio based onits precepts.
Here is a simple summary of how MPT describes the thought process
behind investing:
An investment is made in a security, or portfolio of securities, in an-ticipation of receiving a monetary reward. The expected reward isthe  average  reward  that  results  from  holding  the  specific  invest-ment(s).  Some  years  the  return  on  the  investment  exceeds  the  ex-pected return, and some years the return on the investment is less.
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The investment universe is filled with uncertainties, and, there-fore, there is a certain degree of risk encountered when attempting tocollect the reward. The risk is a measure of the uncertainty of earn-ing the expected return.
Thus (states the theory), an investor chooses among investmentpossibilities based entirely on the two measures of risk and reward,attempting to minimize the former and maximize the latter.
ASSET ALLOCATION AND ITS ROLEIN MODERN PORTFOLIO THEORY
What does MPT tell an investor about how to choose the components of aportfolio? The first idea is to diversify one’s holdings and to allocate part ofthe  investment  capital  among  several  asset  classes.  Reasonably  enough,this strategy is known as asset allocation. Not so many years ago, asset al-location meant owning a variety of stocks and bonds and some cash equiv-alents.  The  prudent  man  rule  reinforced  this  type  of  thinking  amongfiduciaries,  or  those  responsible  for  investing  other  people’s  money.11Today MPT goes further and focuses on the portfolio as a whole, and not onits individual components. But proper diversification remains an essentialingredient of MPT.
When following MPT to build a portfolio, it’s not sufficient to compilea portfolio simply by investing in different asset classes (e.g., stocks, bonds,gold, and real estate). MPT teaches that it’s important to find the optimal al-location of assets satisfying both the investor’s risk tolerance and reward(expected  rate  of  return).  It’s  important  to  own  a  variety  of  investmentsthat perform differently in the marketplace. In other words, there should beminimal correlation in the performance of each individual investment witheach of the other investments. If it sounds difficult to build a portfolio onestock at a time that satisfies these parameters, especially for an individualpublic investor, be assured that it is indeed difficult. But don’t fret, as thereis an easy method to accomplish this goal for the portion of your invest-ment capital that you allocate to the stock market. That method is the basisof this book. A well-qualified financial advisor ought to be able to help youachieve the type of portfolio recommended by MPT for any assets you ownthat are not stock market related.
Again, it’s important to reiterate that our discussion focuses on onlythat portion of your assets you have allocated to investing in the stock mar-kets of the world. This book makes no recommendation on how you shouldotherwise allocate your assets. MPT tells us that asset allocation should notbe ignored, as it represents the best method of reducing the overall risk of
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your portfolio. Numerous books offer advice on how to allocate assets inaccordance with MPT, and we’ll leave that discussion to them.12
THE PRUDENT INVESTOR
The prudent man rule contains guidelines for those responsible for invest-ing other people’s money. The purpose of the rule is to offer protection toinvestors by providing those fiduciaries with investment guidelines. Overthe years, the rule has changed with the times. At one point, it would havebeen  considered  lunacy  to  invest  the  savings  of  a  public  investor  in  thestock market. After World War II, as inflation became important in makingfinancial decisions, it was considered extremely imprudent for a fiduciarynot to  invest  in  the  market.  Today  it  is  not  enough  to  merely  invest  instocks,  and  the  prudent  man  rule  requires  that  fiduciaries  invest  at  leastpart of an investor’s funds via passive investing, using index funds. Passiveinvesting is consistent with the teachings of MPT and represents an impor-tant part of our overall recommended investment strategy. It’s the basis offurther discussion in Chapter 2.
At one time, a fiduciary had the difficult responsibility of being certainthat each investment was appropriate for an investor. Today, taking MPTinto consideration, the prudent investor rule has been revised to “focus onthe portfolio as a whole and the investment strategy on which it is based,rather than viewing a specific investment in isolation.”13 As a result, it’s ac-ceptable for fiduciaries to recommend shares that would be risky as stand-alone  investments,  as  long  as  the  entire  portfolio  is  appropriate  for  theinvestor.
DIVERSIFICATION
Diversification  is  an  essential  element  when  following  MPT.  The  easiestway for public investors to diversify has been to own shares of traditionalmutual funds. Their very existence is one reason why so many Americansare currently stock market investors, as mutual funds make it easy for pub-lic  investors  to  own  a  professionally  managed  diversified  portfolio  ofstocks.14 The wisdom of relying on these professional money managers isone  of  the  subjects  covered  in  MPT  and  this  discussion  is  continued  inChapter 2.
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C H A P T E R   2
Can You Beat theMarket? ShouldYou Try?
The academics say, “No way.” Professional money managers say, “We
do  it  all  the  time.”  What’s  this  argument  about?  It’s  a  debate  overwhether anyone can build a portfolio of stocks that outperforms themarket on a consistent basis. Academics claim the market’s ups and downsare random and that it’s not possible either to time the market1 or predictwhich stocks are going to outperform the market in the future. Money man-agers claim the ability to do research and determine which stocks are un-dervalued and beat the market by buying those stocks. This is an ongoingdisagreement with no end in sight.
Those who believe it’s not possible to beat the market make this argument:
• Gross returns earned by investors as a group must equal the gross re-
turns earned by the total stock market.
• Net  returns—after  advisory  fees  and  other  investment  expenses—earned by investors as a group must fall short of the returns of the mar-ket by the amount of those costs.2
Those  making  this  argument  believe  that  simply  hiring  professionalmanagers and paying fees for their services is enough to guarantee below-average returns over the long term. Their suggestion is to invest in indexfunds  because  those  funds  do  not  spend  money  on  research  and  savemoney  on  commissions  by  owning  and  holding  an  investment  portfolio.These  funds  charge  much  lower  fees  than  traditional  mutual  funds,  andthose reduced fees enable index funds to come very close to matching theperformance of the market (as measured by the index they are trying to
9
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mimic).  This  investment  methodology  is  discussed  further  later  in  thischapter.
Those who believe in the efficient market theory believe that marketsmust be inefficient (information becomes available to different participantsat different times) in order for any individuals to demonstrate the skills re-quired to compile a portfolio of stocks that consistently generates above-average  profits.3 But,  since  they  believe  the  market  is  efficient  and  allinformation that can possibly be known is already known, and that such in-formation is already priced into the price of every stock, they believe noone has any special advantage and therefore no one can consistently out-perform  the  market.  Statistically  there  are  always  some  who  do  outper-form and others who underperform, but there is no way for an investor toknow in advance who can generate above-average returns. Thus, efficientmarket  theorists  conclude,  spending  money  in  an  attempt  to  outperformthe market is a foolish endeavor.
Modern portfolio theory (MPT) agrees with the academics on this issue.Most of the evidence tells us that markets are fairly efficient. As addi-tional advances in information technology become available, the marketswill become even more efficient. If that’s true, then the question remains:With  so  much  information  available  to  everyone,  and  with  sophisticatedsoftware available to analyze that information, is it possible for specific in-dividuals to gain (and maintain) a sufficient advantage that allows them tobuild a portfolio that performs better than the portfolios of their peers? Andif it can be done, is it reasonable for investors to spend time and effort in anattempt  to  find  which  funds  to  buy  to  benefit  from  that  superior  perfor-mance? In other words, can individual investors know which mutual fundsare likely to do well in the future? Is past performance any indication of fu-ture results? Academia concludes that it cannot be done now, and in the fu-ture it will become even more unlikely that anyone can beat the market ona regular basis. The dispute goes on.
This author sides with the academic world and the teachings of MPTand  believes  that  attempting  to  beat  the  market  is  an  expensive,  time-consuming,  and  fruitless  endeavor  for  the  vast  majority  of  investors.  Asnoted in the preface, most investors “feel” they can beat the market and at-tempt that feat year after year.
DO YOU STILL WANT TO CHOOSE YOUROWN STOCKS WHEN INVESTING?
Do you believe that your stock-picking skills are excellent? Do you believeyou  have  a  trading  system  that  allows  you  to  do  better  than  the  market 
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on  a  consistent  basis?  Do  you  believe  technical  analysis  can  tell  youwhich stocks  to  buy  and  when?  If  you  truthfully  answered  yes  to  any  ofthe above, congratulations! You are already able to outperform the marketand don’t have to worry about diversification, risk reduction, or any partof modern portfolio theory. The lessons in this book are for everyone else,although you still can benefit by learning and adopting the options strate-gies  taught  in  Part  III  and  by  learning  to  appreciate  the  advantages  ofdiversification.
The  question  remains:  Is  there  evidence  on  whether  the  average  in-vestor can beat the market by choosing individual stocks to buy and sell?Yes, there is and we’ll take a look at the evidence later in this chapter.
WALL STREET SAYS YOU CAN BEAT THE MARKET
The  professional  brokers  on  Wall  Street  are  in  the  business  of  trying  toconvince public investors that they easily can beat the market if they onlywould open a trading account with their brokerage house and follow theirinvestment  advice.  But,  to  make  money,  individual  investors  must  pickwinning stocks, and, as you will see, the evidence tells us that the vast ma-jority are unable to do it.
Managers of mutual funds take the same path in trying to convince in-vestors to send them money. They often boast (via paid advertisements) oftheir  recent  market  success.  That  advertising  is  effective,  and  investorsrush to buy shares of mutual funds that recently have been able to beat themarket.
RESEARCH SAYS YOU ARE UNLIKELY TO BEAT THE MARKET
Beating the market is a difficult task. With so many individual investors andso many professional money managers trying, the laws of probability tell usthat some will be successful while others will not.
Some investors like to try to beat the market, especially if stock marketinvesting is a hobby. By all means, enjoy yourself. But if your financial goalis to amass wealth over the years, and if your fun comes from success, thenrecognize that the odds are against those who try to beat the market on aregular basis. It’s much easier (and more likely to be the winning strategy,according to modern portfolio theory) to own a suitable mix of ETFs. When
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But I Can Beat the Market
If you still believe you have the ability to beat the market with your indi-vidual  stock  picks,  don’t  stop  reading.  The  strategy  taught  in  this  bookworks very well for investors who compile a portfolio of individual stocks,and gives you the information you need to enhance the return you earn onyour  investments—with  the  added  bonus  of  doing  so  with  reduced  risk.Read on!
you modify your ETF strategy by adopting the methods taught in this book,your chances of enhancing your returns become even greater.4
If  you  still  believe  you  can  beat  the  market  by  selecting  your  ownstocks, then you are certainly free to make the attempt. Just recognize theodds  are  not  on  your  side.  Owning  a  diversified  portfolio  of  ETFs  thatmeets the requirements of MPT can’t be a bad thing. It might be possible tocompile a portfolio by choosing individual stocks that gives you a slightlybetter than expected rate of return or a slightly lower level of risk, but thereare two reasons not to attempt that feat: (1) It requires a great deal of re-search, and (2) it’s not likely to make a significant difference. Professionalmoney managers and individual investors have not been able to beat themarket on a consistent basis,5 and you will probably be better off spendingyour time deciding which EFTs are right for you.
If you are willing to consider the possibility that it’s difficult, if not im-possible, to outperform the market on a consistent basis, that doesn’t meanyou must sit back and do nothing. There are steps you can take to improveyour performance. Asset allocation is the first step.
Once you have allocated a portion of your assets to the stock market,you  can  make  additional  modifications  to  standard  investment  methodsthat reduce your risk and raise your profit expectations. In this book, youwill learn how to outperform the vast majority of investors who blindly buymutual funds or who undertake the task of building their own portfoliosone stock at a time.
WHAT IS INDEXING?
Let’s begin our brief discussion on indexing with a definition. An index is a statistical representation of the performance of a hypothetical portfolio of stocks. That portfolio consists of each stock in the index, in its correctproportion.
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When you choose the investment method of indexing, you are attempt-ing to mimic the returns achieved by the market averages, rather than at-tempting  to  outperform  those  averages.  Today  many  investors  no  longerfeel  it’s  appropriate  to  own  shares  of  actively  managed  mutual  funds—funds in which the managers frequently buy and sell stocks in an attempt togenerate a higher return than competitive mutual funds. Indexers measuretheir performance against a benchmark, often the Standard & Poor’s 500index  (considered  by  many  to  represent  “the  American  stock  market”6).More and more investors and fiduciaries are buying index funds and boththe prudent man rule and MPT favor buying such funds. Public investorshave come to accept owning investments that match the performance ofthe  market  averages,  especially  since  those  average  returns  were  prettyspectacular during the bubble-building years of the late 1990s.7
BUILDING A PORTFOLIO TO MIMIC AN INDEX
An index fund is not hypothetical, but a real-world portfolio of stocks. Themanagers of the index fund attempt to mimic the performance of the index(and its hypothetical portfolio) as closely as possible. The best way to ac-complish that task is to own the correct number of shares of each compo-nent of the index. For some indexes, that’s a simple matter. For example,managing a fund that mimics the performance of the Dow Jones IndustrialAverage  (DJIA)  requires  owning  shares  in  only  30  different  companies.Each stock is actively traded, and the shares are easy to buy or sell. Thus,when the managers of an index fund that mimics the performance of theDJIA receive cash from investors, it’s a simple matter to invest those fundsby buying the appropriate number of shares of each of the 30 stocks. Simi-larly, if there is an influx of redemptions (orders from shareholders to selltheir holdings), the fund managers have no difficulty selling shares to raisecash to meet those redemptions.
However, some indexes consist of shares in a vast number of compa-nies. For example, attempting to exactly replicate the performance of theRussell 3000 index or the Wilshire 5000 index is difficult. Each index con-tains thousands of stocks, and some are very thinly traded, meaning thatonly a relatively small number of shares trade every day. It is not efficientto trade those stocks frequently. When it becomes necessary to buy or sella significant number of thinly traded shares, the fund managers easily couldinfluence the price merely by attempting to buy or sell the shares.8 Thus, it’sa more efficient process to own a representative sampling of the stocks insuch an index, rather that attempting to own each component. Fortunately,
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sampling is a viable strategy, and it’s possible to compile a portfolio thatproduces investment results that are almost exactly the same as if the fundowned each of the stocks in the index.
If you ask why fund managers must buy or sell these thinly traded issues,consider what happens when the management team receives cash from in-vestors. That cash must be invested (proportionately in each of the stocksthat comprise the fund’s portfolio) as soon as possible because holding a siz-able cash position is not conducive to mimicking the market performance ofan index. Holding uninvested cash runs the risk of underperforming in a ris-ing market or outperforming in a declining market. Because matching theindex is the managers’ prime directive, they do not want to take the risk oftiming the market. Neither beating nor underperforming the index is consid-ered to be acceptable, but outperformance is always forgiven.
The managers constantly maintain a portfolio representative of the spe-cific index they are trying to mimic and trade as infrequently as possible.This keeps expenses low. However, when a change in the composition ofthe index occurs (a new stock is added or an existing member of the indexis removed, the portfolio must be adjusted accordingly.)9
When you buy shares of an index fund, you agree to accept a return onyour investment that closely resembles the return of the overall market (orthe market segment the fund is attempting to mimic). By saving manage-ment and execution fees, investors are ahead of the game.
Indexing is still a controversial topic and is likely to remain so for manyyears, but prudent investing favors indexing strategies. One recent book,The Successful Investor Today, gives an excellent summary (including ad-ditional references) that makes the case for accepting passive investing.10Other books on this topic also are available.11
The History of Indexing
The first index fund became available to public investors when Vanguardlaunched the First Index Investment Trust in August 1976. The fund’s namehas  since  been  changed  to  Vanguard  500  Index  Fund.  The  availability  ofsuch funds is important because MPT tells us that owning index funds is thebest  investment  strategy  for  most  public  investors.  Going  even  further,MPT teaches that each investor should own a suitable assortment of indexfunds, ensuring proper diversification. If you accept the argument that se-lecting individual stocks in an attempt to beat the market is not in your bestinterests,  index  funds  represent  an  excellent  investment  vehicle,  as  theyprovide diversification accompanied by minimal management fees. For ex-ample, the Vanguard 500 Index Fund costs investors 18 cents per year, per$100 invested, compared with $1.25 per $100 investment for the average ac-tively managed mutual fund.12
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PASSIVE OR ACTIVE MANAGEMENT?
Portfolios  can  be  managed  passively  or  actively.  The  passive  strategy,which  is  called  indexing,  involves  building  a  portfolio  that  performs  asclosely  as  possible  to  the  performance  of  a  specific  broad-based  index,such as the S&P 500. Passive investing produces less stress for the investor,who no longer has to worry about the performance of the fund’s manage-ment  team.  Of  course,  if  the  market  undergoes  a  steep  decline,  the  in-vestor’s portfolio loses value. For investors who want to be invested in thestock market, indexing is an excellent methodology, according to the teach-ings of MPT, as it provides a way to reduce risk through diversification. Thepassive portfolio manager exercises no judgment in building the portfolio,and no trading decisions are necessary. The most obvious benefit of thisstrategy is reduced expenses, as trading expenses are minimal and researchexpenses are eliminated. Indexing is becoming an increasingly popular in-vestment choice.
The obvious disadvantage of passive investing is the inability to out-perform the market. For some investors that’s acceptable, as there is alsothe inability to underperform the market.
Managing traditional mutual funds is a hugely profitable business. Fundmanagers maintain those profit levels by charging their mutual funds (andthus, the fund’s shareholders) much higher fees than they charge their in-stitutional clients for identical services.13 The managers of actively tradedmutual funds are not going to sit quietly and give up their franchise to thosewho manage funds passively. These management companies spend hugesums on advertising, trying to convince the average public investor that in-vesting with them is the smart thing to do. These managers always leave theimpression they can beat the market averages in the future simply becausethey may have beaten them in the past.14 The year’s best-performing fundspromote  that  performance,  attempting  to  entice  investors  to  place  newmoney in their funds.
When running an actively managed fund, the managers not only choosewhich specific investments to own, but also use market timing strategies todetermine when to invest in stocks and when to hold cash equivalents. Bytiming the market, managers add additional risk to the portfolio, as it be-comes more likely the investment results of the fund will differ from that ofthe overall market.
MPT tells us that passive investing, including being fully invested at alltimes (not attempting to time the market), is beneficial and that the addi-tional expense of paying higher fees to the managers of actively traded mu-tual  funds  is  not  justified.  Of  course,  this  conclusion  of  MPT  is  notuniversally accepted. Those who believe in technical analysis are the mostadamant  in  their  refusal  to  accept  these  premises.  After  all,  if  it  were
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impossible to predict future prices by studying a stock’s price history, thentechnical analysis would be a bogus science. This controversy is not likelyto go away quietly. We’ll take a look at some of the evidence and you candecide whether passive investing is suitable for you.
Do You Make Investment Decisions Alone?
Being in an investment club is fun. It’s a great learning experience for peo-ple who are beginning their investment education. Members usually meetonce per month, discuss various possible investments, and learn how toconduct research to analyze the investment worthiness of a company. Thequestion remains: Do the portfolios compiled by these investment clubsoutperform  the  market?  Surveys  of  investment  clubs  tell  us  that  theseclubs  are  generally  successful.  But  such  surveys  are  flawed.  In  a  studycovering  a  six-year  trading  history  of  166  randomly  selected  investmentclubs (clients of one unnamed large discount brokerage firm), professorsBrad Barber and Terrance Odean concluded that investment clubs “edu-cate their members about financial markets, foster friendships and socialties,  and  entertain.  Unfortunately,  their  investments  do  not  beat  the market.”15
Many  individual  investors  make  their  investment  decisions  on  theirown,  without  the  comfort  of  being  able  to  discuss  those  selections  withother  investment  club  members.  Some  seek  advice  from  professionals,some rely on tips, and some even (I shudder at the thought) seek advicefrom Internet chat rooms. Do individual investors, regardless of whetherthey  seek  anyone  else’s  advice,  outperform  the  market  on  a  consistentbasis?
THE VERDICT, PART I. SHOULD YOUCHOOSE YOUR OWN STOCKS?
The evidence says no. Barber and Odean studied more than 2 million cus-tomer trades over a six-year period and found that individual investors sig-nificantly underperform the market.16 They also found those who make thehighest number of trades, running up the highest expenses, perform worsethan those who trade less. This is an example of actively managed accountsperforming worse than less actively managed accounts.
It may not be surprising that public investors who trade actively un-derperform their peers who trade less often, but can the situation possiblybe the same for accounts managed by professional mutual fund managers?See the Verdict, Part II in Chapter 5.
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ACCEPTING THE CONCEPT OF PASSIVE INVESTING
If you, as an individual investor, cannot expect to beat the market on yourown, what can you do? Must you accept below-average returns? Must youpay someone a fee in an attempt to earn better returns? Fortunately, there’san acceptable alternative. If you are willing to give up the dream of makingan overnight killing in the market and to accept the fact that beating themarket on a regular basis is an unlikely occurrence, then you can make thedecision to accept returns that match the overall performance of the mar-ket. If you do that, you gain:
• Bottom line: You make more money. Average returns are better than
below-average returns.
• Your trading costs are reduced, allowing you to make more money than
those who invest in traditional mutual funds.• Passive  investing  involves  fewer  trades,  lower  commissions,  and
lower management fees.
• By not selecting your own stocks, you trade less often, reducing costs.• You  no  longer  have  to  spend  time  researching  stocks  to  buy.  Nomore analyzing balance sheets to determine financial soundness. Nomore studying historical stock price charts. No more depending onothers for investment tips.
• The volatility of the value of your portfolio is reduced.• Your tax situation improves, as passive funds seldom pay capital gains
distributions.
• You suffer less stress, as you know in advance that the value of yourportfolio increases or decreases in line with the market averages.
As mentioned earlier, owning index funds is becoming more and morepopular, and the number of investors who choose to own shares of indexfunds is increasing. Even the current adaptation of the prudent man rule en-courages this investment choice.
The managers of actively traded mutual funds are not going to disap-pear, and they are not going to stop trying to convince you to give them yourmoney to manage. That’s a good thing, both for you as an indexer and for themarket. In order for investing in index funds (indexing) to work well, theremust be those who do not adopt this strategy. If everyone owned only indexfunds, there would be virtually no trading. If neither investors nor profes-sional money managers were attempting to beat the market, no one wouldbe buying or selling stocks. Everyone would own the same or similar port-folios. Don’t be concerned: Human nature being what it is guarantees thatthis  will  never  happen.  Be  satisfied  that  if  you  choose  indexing,  you  are
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making an investment choice that puts you ahead of the game. If indexingdoes not sound like something that appeals to you, be patient. In Part IVwe’ll use options to improve the performance of passive investing—an im-provement that increases profitability and reduces risk.
Summary
The normal distribution