A Simple Way to Beat the Market

Last Updated May 26, 2010 7:03 AM EDT

The evidence from decades of academic research is that only a small percentage of investors outperform the market over the long term. The quest for the "Holy Grail" of outperformance has mostly proven to be counterproductive. Tens of billions of investor dollars are spent (wasted) every year in an effort to identify and hire managers who are expected (but most often fail) to deliver market-beating returns. And tens of billions more are spent by individual investors trading on their own in a similarly ill-fated effort.

Despite the failure of most investors to beat the market, there's actually a very simple way to do so. For the period 1927-2009, the U.S. stock market (as represented by the CRSP Deciles 1-10 Index) returned 9.6 percent per year. Over the same period:

  • Small-cap stocks (as represented by the Fama/French US Small Neutral Research Index) returned 13.2 percent per year.
  • Large-cap value stocks (as represented by the Fama/French US Large Value Research Index) returned 11.8 percent per year.
  • Small-cap value stocks (as represented by the Fama/French US Small Value Research Index) returned 14.9 percent per year.
Thus, while investors were spending billions in active strategies -- such as stock selection, market timing and manager/fund selection -- that produced poor results on average, there's available a simple strategy to beat the market: Invest in passively managed funds that buy small-cap and value stocks. Doing so has delivered market-beating results. Simple, however, doesn't mean easy.
During this period, the annual standard deviation (a measure of volatility and risk) of the market was 20.6 percent. The standard deviations of small-caps, large-cap value and small-cap value stocks were all much greater at 29.0, 27.2 and 32.0 percent, respectively. Thus, you would have had to endure wilder rides and have had the patience and discipline necessary to stay the course.

Besides greater volatility, you would also have to endure "tracking error regret." Tracking error refers to the degree to which the return of an investment differs from the return of a selected benchmark. The evidence is that while investors don't seem to care about positive tracking error (outperformance), they do care greatly about negative tracking error. This can lead to sales and the abandonment of the strategy.

To benefit from the long-term outperformance of the other asset classes, investors would have been required to have the discipline to ignore long periods of underperformance (negative tracking error). For example, for the period 1984-90, small-cap stocks underperformed the market by almost 4 percent per year (9.0 versus 12.9). For the six-year period 1969-74, they underperformed by about 7 percent per year (-12.1 versus -5.3).

The same type of negative tracking exists for value stocks. For the period 1994-99, the market returned 22.6 percent per year, outperforming large-cap value stocks by nearly 8 percent per year and small-cap value stocks by 6.4 percent per year. Tests of discipline also occur over much longer periods. For example, for the period 1987-99, the market returned 17.5 percent per year, outperforming large-cap value and small-cap value stocks by 2.5 and 2.0 percent per year, respectively.

On Friday, we'll learn about another simple way to beat the market.

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    Larry Swedroe is director of research for The BAM Alliance. He has authored or co-authored 13 books, including his most recent, Think, Act, and Invest Like Warren Buffett. His opinions and comments expressed on this site are his own and may not accurately reflect those of the firm.