Chops Money

Beating the Market - The Chops Theory

Thursday, May 7th, 2009 | investing

Nobody Can Beat the Market

Any investor who has been around a while has heard that they can’t beat the market.  After hearing it so many times, you start to believe it.  Pretty soon, you want to move all of your money into an index fund.  Then you light your torch and grab your pitchfork ready to storm the gates of whoever tried to sell you an actively managed mutual fund with a high expense ratio.  And if anybody still believed they could beat the market, they could be shown research that shows that the majority of actively managed funds fail to beat the market.  But is it that simple?

Before we look at this problem we need to agree on some definitions.  When people say you can’t “beat the market” they are usually referring to the S&P 500 index.  And even then, it usually comes with some conditions:

1.)  You can’t beat the S&P after costs.
2.)  You can’t beat the S&P consistently over many years.
3.)  You can’t beat the S&P without taking on additional risk.

It sounds like we’re defeated already.  With all of this stacked against us, how can we possibly beat the S&P?  Before we give up, we need to look at exactly what the S&P is.  It’s simply an index comprised of the stocks of 500 large, well known companies.  But wait, there’s thousands of stocks in the world - how do we choose these 500?  Answer:  They are chosen by Standard and Poor’s, which is a research company.

Aha!  So the S&P 500 is chosen by people!  Once you realize that, you can turn the phrase “you can’t beat the market” into “you can’t beat the people picking the stocks in the S&P 500″.  And that truly doesn’t make sense.  It implies that the people working at Standard and Poor’s are the best stock pickers in the world and they always have been and always will be.  We know that can’t be right.

So then what do fund managers do wrong?  The reason they don’t beat the S&P 500 is because they don’t play by the S&P’s rules.  You don’t outrun a horse with a bicycle - you outrun it with a better horse.  This boils down to:

1.)  They have too much turnover.
2.)  They have either too many or not enough stocks.

For example, look at the Fidelity Large Cap Value Fund (FSLVX).  It tries to beat the S&P 500 but it doesn’t play by the same rules.  This fund holds 105 stocks instead of 500.  Turnover is 243%.  And it doesn’t beat the S&P 500.  If you told Standard and Poor’s to make a fund that plays by those metrics, I’ll bet they couldn’t do much better.

But we don’t have to look to mutual funds if we want to beat the S&P 500.  Other indices do the job just fine.  Over the last 30 years the NASDAQ has beaten the S&P 500.  And over the course of its life, the Wilshire 5000 has a slight gain on the S&P.  Other indices have failed.  The Dow Jones (which is only 30 stocks) has racked up about 50 years of losing to the S&P.

So, as I see it, it’s not that the market can’t be beaten.  It’s that everybody is trying the wrong way.

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