“Lies, damn lies, and statistics” was popularised by Mark Twain to describe the persuasive power of numbers.
For many years I’ve replaced damn lies with facts. Lies, facts and statistics.
Facts, like statistics, can tell you whatever you want to believe. Many people believe the are looking at the truth through the lens of either statistics or facts, but they are often simply seeing what they wish to. They then use the “lies” to entrench their position.
Facts and statistics are often the trees stopping us from seeing forest.
I’m not implying it’s always best to focus on the forest, sometimes it’s the trees we need to look at. The important part part is to have the right focus for the circumstances, an open mind, and not to swallow statistics or facts without chewing.
Statistics tell us that retail investors woefully under-perform the market. Stats also highlight around 75% of fund managers lag the market. Many people concentrate on those dire figures and in the case of ETF and index funds heavily publicise them.
So why would a retail investor bother trying to outperform the market? Statistics say it is highly unlikely and individual investors are seriously out-gunned by institutions.
The answer is, invert those statistics.
Can retail investors outperform the market?
Market returns are the average of all participants. So if the vast majority of participants under-perform the market then a minority must be trouncing the market.
I occasionally communicate with one of these market thrashing investors. Here are his returns to October 2014
Those are some awesome numbers. For some perspective on how good his performance is consider this. Over the last 5 years he would have turned $100,000 into almost $410,000 and over the last 3 years $100,000 would have grown to almost $290,000. Simply phenomenal.
Now let’s compare his returns to mine.
While we both handily thrashed the market, I trail by a considerable distance. Even though my performance over 5 years appears pretty close to his, it’s not. Instead of growing to $410,000 over 5 years, I would have “only” grown it to $309,000. A few percentage points makes a huge difference.
Investor X wonders why I hold such a high cash balance, around 50 percent at the moment.
One comment I would have, is the fact that you have moved to around 50% cash. I also watch Geoff Wilson’s performance with his LICs WAM, WAX and WAA, and he also likes to keep between 30-50% cash. I have always thought he could do a lot better if he was prepared to be more fully invested. Yes, you are both in an excellent position to take advantage of the down turn we are now in, but I wonder at the cost of lost opportunity. I rarely have more than 2-3% in cash. If I sell something, it is because I have found what I judge will a better investment to move onto.
Investor X is right. My returns would be much closer to his over the last 5 years if I was 100 percent invested. While close to meaningless, we’ve also compared monthly volatility and my portfolio is more volatile. So why do I hold so much cash?
The simply answer is personality. While investor X was able to live with a 60 percent fall during the GFC, I could not. Our portfolio dropped around 20 percent during the 2008 market crash. I prefer to sacrifice some upside to ensure I can sleep well at night.
The other answer is buy fear sell greed. While many market pundits present facts and statistics showing that the market is under or over value, or just right, I focus on the trees, the individual companies. I raised cash in September as companies I held became overvalued. I’ll redeploy capital when it’s easy to do so, when companies I want to buy are being sold by fearful investors.
Investor X is older and probably wiser than me. He clearly has better performance over the last 5 years. But what happens if we layer on our respective 60 and 20 percent drops?
It turns out if we started with a $100,000 prior to the GFC and our returns included both the falls and gains from above then investor X’s portfolio would now be worth $164,000 while mine would be $247,000. Naturally if we exclude the GFC drop, but our portfolios fell by similar amounts now, the figures would be the same, i.e. $164k and $247k.
I’m not saying this is what happened or will occur, but I hope it illustrates why I focus on the downside. If not then perhaps this graph of gains required to make you whole again will.
See the difference. While it only take a 25 percent gain to make up for a 20 percent loss, it takes a massive 150 percent increase to recover from a 60 percent drop. (See this post on the lies behind this accepted fact and how it can take exactly the same percentage gain to make up for a loss.)
I am so far off topic I should change the title, but hopefully through the many diversions you can see two retail investors thrashing the market in two different ways. While there are many wrong paths, there is no one right path to market outperformance. Each investor must fine the path that is right for them.
Some paths are easier to follow as they are clearly marked. Value, momentum and small caps are 3 paths that have provided strong tailwinds for up to 9 decades now.
A little meat
During September I sold, Analytica Limited (ASX:ALT) and Global Health Limited (ASX:GLH), and reduced M2 Group (ASX:MTU) and My Net Fone Limited (ASX:MNF).
While I say it’s the companies I focus on, that is simply part of the story. Market corrections are not fair to all comers. Some stocks get whacked 90 percent, some might only drop 10 percent and there will even be a few gainers.
In general stocks that are any of overvalued, speculative, small caps, without earnings or popular are hardest hit.
I continue to hold some stocks that are likely to get clobbered in a correction. Two companies that jump to mind are Somnomed Limited (ASX:SOM) and Nearmap Limited (ASX:NEA). I hold these and would look to buy on a correction as it is simply too difficult to ‘time’ individual growth stocks.
Disclosure: Long MTU, MNF, SOM and NEA.