It Is Hard To Beat the Index If You Are Picking Stocks From the Index

Heinz Baked Beans

20 Aug It Is Hard To Beat the Index If You Are Picking Stocks From the Index

We are bias.

Pathetically 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.

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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?

S&P 2013 Year End SPIVA

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.



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10 Comments
  • Richard Ng (Invest Openly)
    Posted at 11:43h, 20 August Reply

    I guess being bias is just being human! ;-)

    All the best to your next intake of VIMC.

  • YJ
    Posted at 22:44h, 20 August Reply

    Teh Hooi Ling presented in a recent conference that if you have a portfolio that is **equal weighted** in the STI index stocks, you actually beat it. Problem is most index is that it is market cap weighted.

    • Alvin Chow
      Posted at 07:19h, 21 August Reply

      Yes YJ. It is possible to pick stocks from the index to beat the index. I said it was hard, but possible. But even so, I wouldn’t expect the returns to differ by a large margin. I would rather buy STI ETF than trying to pick index stocks and risk underperforming it.

  • My 15HWW
    Posted at 23:07h, 20 August Reply

    Hi Alvin,

    Generally, small caps perform better than the large caps. Higher returns to compensate for the supposedly higher volatility.

    The more conservative might still prefer to select some stocks from the STI even after knowing this. Able to sleep more soundly at night matters too. =)

    • Alvin Chow
      Posted at 07:22h, 21 August Reply

      I agree that the risk premia is higher for small caps but not necessary higher volatility. Most small caps are boring, the price doesn’t move.

      If an investor is conservative and is worried about volatility, then I think stocks are not suitable, regardless big or small cap.

      He should get a higher weightage in bonds than stocks or construct a Permanent Portfolio.

      Yes, sleeping soundly at night is an important consideration :) which most people tend to ignore when they are blindsided by potential gains!

  • Createwealth8888
    Posted at 08:00h, 21 August Reply

    Only when one has the patience and gut for the right time to pick a few blue chips during crisis to plant money tree.

  • gagmewithaspoon
    Posted at 12:33h, 21 August Reply

    Hi! pretty new to this but wondering how to purchase Vanguard 500 if we are in singapore? etrade?

    • Alvin Chow
      Posted at 07:53h, 27 August Reply

      You can buy Vanguard ETFs through your broker which gives you access to US markets.

  • We Beat the STI Returns by 4 Times
    Posted at 09:05h, 27 August Reply

    […] should dismiss the stock. I have written about how we can be so bias even for the name itself. You can refer to this article. For us, we do not have the preference for or against the stock. We are objective and we will take […]

  • Here’s Why Your Stock Returns Are Suffering
    Posted at 16:08h, 09 March Reply

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