Here are Six ways that investors can attempt to achieve higher than average returns on their investments.
- By dumb luck
- By investing in the Market Index and using borrowed money to create leverage
- By taking on more Risk
- By using charting and momentum techniques to outsmart other investors
- By using rumors and inside information to gain an advantage over other
investors - By using value analysis techniques to identify under-valued investments
Each of these methods is explained below. In each case, I also discuss who ends up paying for these higher returns.
1. Dumb Luck
Sadly this is probably the most popular strategy. Investors cobble together a collection of stocks, bonds, equity mutual funds, and money market funds. There is often little rhyme or reason for the selected investments. Some selections will come from broker advise, some are bought after reading an article in the newspaper or seeing some company featured on an investment show.
The chance that such a portfolio will out-perform the market is basically random. Therefore, it will not be at all unusual if some such portfolios get lucky and beat the market for a period of time or in rare cases for years on end. Others will badly lag the market. Due to broker and mutual fund fees, the average portfolio will lag the market.
To the extent that some people do achieve high returns through good luck, this would come at the expense of those with bad luck.
The obvious problem with this method is that it relies on luck and therefore is not a reliable route to high returns.
However, investors who achieve high returns using any other method should always be aware that good old dumb luck may be largely responsible for their superior results.
2. Market Index Combined With Cash Investments or Borrowing
This method is based on the theory that the market portfolio is the most efficient portfolio based on risk and expected reward. Your portfolio risk and expected return can be easily adjusted downward by splitting your funds between a market index and short term risk free investments such as Treasury Bills. Alternatively, your portfolio risk and expected return can be adjusted higher by simply borrowing additional money and investing all funds in the market portfolio. The market portfolio consists of an index fund for a broad stock market index and should also include an index bond fund and may include some foreign stock and bond index funds.
This method has strong theoretical grounding and has much empirical support. For more about the theory see my article, Practical Lessons From from Modern Portfolio Theory.
The advantages of this method are that in theory it will reliably yield higher returns in the long term, it is very easy to apply, and trading and management fees are very minimal.
One disadvantage is that there is no clear rule for setting the exact make-up of the market portfolio including the proportion of the index funds that should be in stocks versus bonds or domestic versus foreign assets.
Another disadvantage is that you could go broke waiting for the method to work out in the long term. Using borrowed money (as long as it can be borrowed at reasonable interest rate) will lead to a higher expected return compared to the market. And over a long time period it is extremely likely that the actual return will in fact turn out to be higher than the market (this simply requires the average market return to be higher than the borrowing costs). However, an investor has to be able to fund the borrowing along the way and must be prepared and financially able to resolutely stay the course during bear markets. Over a long period of time there is very little (but still some) risk that the investor will earn less than an average market return. The price for this highly reliable superior return is the fact that your portfolio will definitely be more volatile than the average market.
This method works reliably in the long run but is very boring. Some people are not attracted to a method that requires little or no effort or thought. But most people find this to be an attractive feature of the method.
A very strong argument can be made that this is by far the best and most reliable method to obtain higher than average returns, though it comes at the expense of higher volatility.
The higher long term return that is highly likely to result from this method comes at the expense of those who are willing to loan out funds at a low interest rate. There is no need to outsmart these lenders. They may have short term investment horizons or are risk averse. They are perfectly happy to loan you money (through a bank) at a relatively low interest rate which you can then invest in the market at an expected rate of return that is higher than your borrowing cost.
Personally, I am happy to use this logic to invest fully in risky assets and to avoid investments in “cash”. However, I am not prepared to borrow money to increase my leverage and long-term return. I am simply not comfortable with borrowing to invest notwithstanding the higher probable long-term return.
Also, in following this method it would be wise to increase the cash component at any point in time where it was appant that the market was quite possibly over-valued compared to historical P/E ratios.
Perhaps the ideal way to use this method ids to select a percentage of money to allocated to cash or to be borrowed. Then, resolutely rebalance at least once a year to maintain the target cash percentage. This forces you to sell the market when it rises and buy the market when it has fallen (Buy low, sell high, often said, seldom done!).
3. Adding Risk
This method is a more general version of item 2 above. One key difference, this method will not work.
Many people mistakenly believe that taking on more risk always leads to a higher return. They are a just a little bit correct and a whole lot wrong due to gross misinterpretation of the theory.
In fact, the theory (such as the Capital Asset Pricing Model and the Security Market Line) is that taking on more (compensatable) risk in an efficient manner will lead to a higher expected return. Expected is a key word, there is no guarantee at all that the actual return of the risky portfolio will be higher. Over short time periods such as less than 5 years, there is a very significant probability (significant but less than 50%) that the actual return will be less than the market return. Over long time periods it becomes highly probable (but never quite certain) that the higher market (efficient) risk will lead to a higher return.
The main key words are efficient and compensatable risk. The theory is that some portfolios are more efficient than others in terms of return versus risk. According to the theory the overall market (the entire market of stocks and bonds and other risky assets) is the most efficient portfolio. The theory actually indicates that is quite possible to take on risk in an inefficient manner and that inefficient risk will not be rewarded. For example putting all of your money into just one stock creates an inefficient risk that cannot be expected to reliably lead to a correspondingly high reward. The theory actually indicates that certain risks can be diversified away in an efficient portfolio and that no additional return is associated with such diversifiable risks. These inefficient risks are not compensatable.
So, the market only rewards efficient risks, it does not reward stupid risks. People who believe that any risk that they take on will be rewarded (at least over the long term) by higher returns are sadly mistaken. Sadly this is an extremely common view since so many people know just enough about risk and return to be dangerous to themselves. They correctly understand the theory that higher returns usually require higher risks but they don’t know that only efficient risks are compensated in the market.
Note that the way that the market rewards efficient risks is by setting the price of assets with with compensatable risk lower than the price of comparable lower risk investments. If a stock seems over-priced then it is risky but this particular risk is an inefficient risk, one that the market cannot be expected to compensate.
4. Charting and Momentum Techniques
This method relies on trying to predict which way the market and individual stocks are going, in the short term, based patterns of price and volume movements. The extra return from this method is earned at the expense of other traders who are selling or buying at the wrong time.
This is a zero sum game except that after trading fees the average investor using this method must lose ground compared to simply buying and holding the market average.
The advantage of this method is that extremely high returns are possible. If you can reliably predict the market in this manner than you can far surpass the market average return. And if your method is reliable then you are not in fact taking on higher risks.
Disadvantages are that this method requires very close attention to the market during the trading day. It also usually requires investors to make frequent and lightening fast decisions and trades. It often requires investors to close out trades that move the “wrong way” taking their losses and moving on. Many investors are unable to stomach taking losses and making such fast decisions. This method also leads to very high trading and management fees which sharply undermines the ability of this method to actually work.
Most academic research has found little or no support for these methods. The average investor should not expect this method to work reliably.
In conclusion this method could work for some people but due to trading costs is much more likely to lead to lower than average returns in the long run.
5. Rumors, Inside Information and Breaking News
This method consists of tapping into sources of news and then reacting before the market.
This is a zero sum game that earns excess returns at the expense of those who happen to be trading the opposite way, unaware of the rumor, inside information or breaking news.
This method should work as long as one has early access to accurate rumors, inside information or breaking news.
Disadvantages include the possibility of being caught violating securities laws and of falling victim to false rumors. It also often requires close attention during the trading day and an ability to make and act on decisions in a lightening fast manner.
Overall, this is “good work if you can get it” but is not a realistic method for the average investor.
6. Using Value Analysis Techniques To Identify Under-Valued Investments
In essence this method relies on identifying assets that are mis-priced in the market.
Value investors believe that the market does not always get the prices right and that it is possible to identify undervalued securities.
The excess return is made at the expense of those investors who cannot see the mis-pricing. Value investors tend to be infrequent traders and so trading fees are not a major issue.
For the entire population of investors, value investing is a zero sum game, the gains come at the expense of others. However, it appears that the gains come at the expense of those that follow other methods and not at the expense of other value investors.
A disadvantage of this method is that it is very difficult to calculate the proper value for a stock. Valuation requires accurately forecasting cash flows to an investor and also properly applying an appropriate discount rate for the level of compensatable risk. (However, Warren Buffer has argued that a significantly under-valued investment is always a low risk investment and therefore he uses a constant discount rate for all such assets based on long term bond yields.)
Another disadvantage of this method is that the market may in fact be quite efficient and therefore may be pricing the stocks correctly. Value investors will often be mistaken and the stock will not move as expected, even over an extended period of time. Some value investors follow simple, mechanical approaches such as buying low price to book value stocks. Other value investors calculate intrinsic value using complex models which require much study and effort.
The advantages of value investing include the fact that academic research has provided some support for the more mechanical approaches. The most successful investor of all, Warren Buffett, follows a value approach. And, he has documented other investors who learned this method from Benjamin Graham and who have also achieved consistently stellar results in a way which he demonstrates cannot be explained as random luck. Value investing is also intuitively attractive to many investors.
The excess returns hoped for in value investing do not necessarily come at the expense of higher risk. In fact Warren Buffett argues that buying undervalued stocks significantly reduces risks in comparison to buying a market portfolio. In support of this consider that Mr. Buffett’s investment company, Berkshire Hathaway has never once suffered a decline in book value in the 36 years that he has managed the company.
In conclusion, value investing is an option that investors who have the time and inclination should consider because it promises both higher returns and lower risks.
Conclusion
Borrowing extra funds to invest in a market index portfolio is a reliable and easy route to higher than average long term returns for most investors, but investors must be able to understand and handle the volatility and fund the borrowing.
A lower risk approach is possible through value investing but it requires intensive time and effort to identify and profit from market inefficiencies.
The other methods discussed above that purport to beat the market probably don’t work reliably or are inaccessible to the average investor.
Copyright September 30 and October 7, 2001
Shawn Allen, CMA, MBA, P.Eng.