20 Aug It Is Hard To Beat the Index If You Are Picking Stocks From the Index
We are bias.
I remembered a BBC documentary on Superbrands where the TV host did an experiment on brand perception.
The TV host filled two jars with Heinz baked beans. He labelled one jar with a Heinz sticker and another jar with Tesco baked beans sticker.
He got passer-bys to try beans both jars and asked them for their preference. We know it is the same beans but surprisingly, most of the testees could actually tell the differences in taste! They all said they preferred the Heinz version.
I noticed this bias is present in stocks too. Let’s confess, there are some stocks you like more than the others.
How about Singapore Press Holdings and Hong Fok? Most investors would prefer SPH because it feels sturdy and safer as an investment. Even if SPH is over-valued compared to Hong Fok, most investors will still put their money with SPH because it is more comfortable to do so. Unknowingly, we are using our emotions to decide. Thereafter, we will seek out information that will support our decision on SPH, falling into the confirmation bias trap.
How can we then make use of this bias and turn it into our advantage?
We found our answers in the Standard & Poor’s study.
S&P compares the performance of Index Funds and Actively Managed Funds every year, and it is known as SPIVA in short. I know, I have been emphasizing the fact that most actively managed funds cannot beat index funds and it is better for you to invest in the latter. This is largely true but not entirely true because there is a group of actively managed funds consistently beat the relevant index benchmarks. Can you identify which is it in the table below?
Let’s focus on the five years results. I love long term results as they reflect more skill than luck. The % shows the proportion of actively managed funds beaten by the index. For e.g., 66.24% of the Global Funds were beaten by S&P Global 1200.
I want to draw your attention to International Small-Cap Funds because they performed the best. Less than half (45%) of the International Small-Cap Funds were beaten by the index (S&P Developed Ex-U.S. Small Cap). There seems to be more Alpha in this universe of stocks compared to the bigger cap ones.
One of the reasons which result in this imbalance towards small cap stocks is likely due to the bias I mentioned in the earlier part of this article. The desire or preference towards all stocks are not uniform. There are popular stocks and unpopular ones and the latter tends to be the small caps.
Before you get all excited and going to invest all your money in small caps, I better highlight a flaw. While it is fair to compare a small cap fund against a small cap index, we should also compare the performance between a small cap fund versus a big cap index. Because if the small caps cannot beat the big caps, it makes sense to just buy the big cap index funds.
In our local context, the main stock index is the STI and it is a big-cap index. When we pick stocks, even if it is small caps, it makes sense to compare the performance to STI.
But I wouldn’t recommend you to pick the big caps. Why? It is difficult to beat the index if you are picking the stocks from the index! If you are buying DBS, OCBC, SPH, Keppel and other popular big caps, aren’t you going to get close to the index results? Worse, you pay higher commissions because you have to buy and sell more stocks instead of an STI ETF.
In BigFatPurse, we are different. We invest in small cap stocks because it is easier to get alpha in this part of the stock market.
Even Warren Buffett mentioned about the prowess of small caps in his interview with Business Week in 1999,
“If I was running $1 million today, or $10 million for that matter, I’d be fully invested. Anyone who says that size does not hurt investment performance is selling. The highest rates of return I’ve ever achieved were in the 1950s. I killed the Dow. You ought to see the numbers. But I was investing peanuts then. It’s a huge structural advantage not to have a lot of money. I think I could make you 50% a year on $1 million. No, I know I could. I guarantee that.”
“The universe I can’t play in [i.e., small companies] has become more attractive than the universe I can play in [that of large companies]. I have to look for elephants. It may be that the elephants are not as attractive as the mosquitoes. But that is the universe I must live in.”
Warren Buffett stopped investing in small caps not because they have inferior returns but because his capital has grown too large. As retail investors, we have small capital and are in the best position to look for mosquitoes, and that is the universe we should be living in, not Warren Buffett’s universe.
We share our stock picking methodology in our one-day Value Investing Mastery Course. All the past attendees had remarked that this is a very undervalued course. Hope to see you soon.