What Does It Means to Beat the Market and How I Did It
, on August 29, 2007
You may have heard the phrase beat the market. In this case, the market usually refers to the S&P 500 index. There are other U.S. indices such as, DJIA, NASDAQ 100, NASDAQ Composite, Russell 2000, Wilshire 5000, and many other domestic and international ones. However, the S&P 500 is by far the most used benchmark for investment performance. It is a good benchmark because it represents a well diversified portfolio of large and medium, as well as value and growth, stocks in many industries.
Comparing Your Investment Performance Against the Market
An investment that returned 15% sounds spectacular. However, if this happened in 2003 when the S&P 500 returned 28%, then it’s terrible. By comparing against the S&P 500, you get a more accurate measure of your investment true performance.
When I first started, I made several mistakes; including comparing my investment performance against a fixed number like 10%. After a few years, I learned that it is better to compare against an index — and have been doing it since. Of course, as your portfolio becomes more sophisticated incorporating various asset classes, you will be introducing tracking error, which will make comparing against the S&P 500 alone less useful.
Why Beating the Market is a Big Deal
You may also have heard people talk about how hard it is to beat the market. Let us look at the Vanguard 500 Index (VFINX):
- It is classified as a Large Blend fund according to Morningstar
- There are currently 2,170 mutual funds in this Large Blend category
- This year VFINX ranks 38.99%. In other words, it performs better than 1,324 funds that are actively managed by professional investors!
- Its expense ratio is only 0.18% compared to category average of 1.13%
The last two bullets are the main reasons why so many people choose to invest their money in index funds. As such, beating the S&P 500 is actually quite an accomplishment for any stock investor.
Show Me the Numbers!
You can see from the table below (column H) that my 401k managed to beat the S&P 500 from the end of 2000 through the end of 2006. I do expect to beat, or at least come close to, the S&P 500 by the end of 2007.
Note: Prior to 2000, my 401k underperformed because I was over-allocated in my company stock
Chart updated October 1, 2007
A few notes:
- Column E — S&P 500 performance reflected index growth plus dividend yield; using last trading day of the year data from Yahoo! Finance Historical Prices.
- Column G — My 401k performance discounted my company matching contribution; otherwise the return would be about 1-2% higher
- Column I — My IRA did not perform as well, due to late contributions and lack of certain advantages that I will share later. As for contributions, I ended up contributing in April of the following year instead of right at the beginning of the contribution year. This is something I am planning to correct.
Next, the following table shows how $10,000 invested in my 401k (column B), VFINX (column C), S&P 500 (column D), and IRA (column E) grew at different pace.
Chart updated October 1, 2007
Here is a graph of the table above.
How I Beat the Market
You might be disappointed to learn that I did not have any investment secret to share. The performance you see here was the result of sacrifice, patience, and discipline to stick to a plan. Here are the factors I believe contributed to the superior performance:
- Regular Contributions — With my 401k, I invested more money every 2 weeks. This allowed me to buy more shares when the prices of the funds are low and less when the prices are high.
- Aggressive Asset Allocation — Since I have over 30 years, I decided to be aggressive with my investment — e.g., take on more risk. My current asset allocation is 20% Large Cap, 20% Mid Cap, 20% Small Cap, 30% International, 5% Company Stocks, and 5% REIT.
- Regular Reallocation — I reallocated my funds (at no charge) when the asset allocation shifted by a few percentage points. This allowed me to shift money from good performing funds to buy more shares of the laggards. This basically helped me “buy low and sell high,” and at the same time reduced the downside risk.
- Automatic Reinvestments — as you can see from “Introduction to CAGR,” the difference between S&P 500 with Dividend Yield (green line) and without (blue line) was dramatic. My 401k plan automatically reinvested all fund distributions. This allowed the full power of compounded growth to work.
- Strong International Fund Performance — In the past few years, my international investments performed much better than my domestic investments. One of the reasons behind this may be the weakening U.S. currency. In any case, this gave me a nice boost.
Well, that is pretty much how I did better than the S&P 500 in a nutshell. I am still working on refining my stock picking skill, which I have been getting mixed results. For example, I have picked winners like Staples (SPLS), but also got some losers like Flemings (FLMIQ) and eToys (ETYS).
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