How To Beat The Market!

The last six months have been a great six months for both active and passive investors. I had every intention of blogging about my investment strategies and sharing my thoughts with all. However, rather than blog, i decided, i would just get on with making some brilliant returns, and they have been brilliant. Therefore no time for blogging. Sorry.

I am sort of the person that believes rather than talk a good story, the best way to show to others is actually do it. Whether it is dental practices or trading shares, i would only expect others to do what i say if i have actually done it myself. Far too often, i hear and read of people doing what experts tell them, yet the expert has never actually done what they are suggesting. My brief time as a Management Consultant at PricewaterhouseCoopers and an analyst in the City taught me how to be a master of consultancy and analysis, however, i have only become a strong investor in business and shares by doing it myself (and of course by making plenty of mistakes!).

In this edition of our newsletter, you can read my piece about "How to beat the market! - Passive vs Active vs DIY Investing". In particular I highlight the benefits of DIY investing (assuming you know what you are doing) as opposed to investing in managed of tracker funds. I genuinely believe and feel that most individuals can manage their own funds and grow their own weatlh smartly, as opposed to using funds that charge and take away a lot of the returns. If you like what i say in this piece, and want to know more then i would suggest you then join us on our "Master your Wealth" day on the 30th October 2009. If you want to take control of your own financial well being, and not leave it to so-called experts, this day will be the impetus for you to do it! This will be a very small group, for more details and to book click here.

Passive vs Active vs DIY Investing

I personally don’t understand why people invest in ‘tracker’ funds. Why pay someone just to replicate the performance of the index?

A friend I was talking to the other day was singing the praises of this kind of ‘passive’ investing. He made the point that you may as well go passive since few active fund managers can beat the index over a sustained period. And that’s fair enough.

But to me it misses an even more important point. You don’t need to settle for market-tracking returns. It’s perfectly possible for individual investors like you and me to beat both passive and active funds by picking suitable stocks.

Let me show you what I mean...

There’s little doubt that index, or passive funds are a much better bet than actively managed funds. John Bogle, who founded the well-regarded Vanguard Group of index tracking funds in the US, has done a detailed comparison. The arguments in favour of index funds over actively managed funds are convincing.

Most actively managed funds don't beat the market in the long run

For example, he followed all 355 equity funds existing in 1970 over the period from 1970 to 2005. Of these, 223 did not survive to 2005. Only 24 of the remaining 132 beat the market by at least 1% per year. Just nine of those 24 beat the market by at least 2% per year and two beat it by 3% or more.

Choosing one of the few outperforming funds also proved to be difficult. Bogle looked at the 20 top performing funds in each year from 1995 to 2005. He found that the average rank of these top 20 funds in each following year was 619! In other words, if you bought one of the best funds one year, it often ended up being among the worst funds the following year.

One of the reasons the funds did so badly is their high costs, which are compounded over the years. Another reason is that funds advertise most heavily when the markets are reaching a peak. That means most investors invest more when shares are expensive rather than cheap.

Finally, large funds find it hard to invest in the stocks that are most likely to show the best share price growth. This is one area where smart individual investors have a serious advantage over fund managers. Here’s why. Let’s assume that a fund manager has 50 stocks in a £1bn fund. That is £20m per company on average. Now the manager will probably not want to own too large a percentage of any one company’s shares. This means that for a £20m holding that's worth, say, 3% of a company, he is limited to stocks with market caps over £660m. This figure will be even higher for a larger fund.

This means the fund must concentrate mainly on larger companies – the FTSE 100 if it is a UK fund. Indeed, many so-called active funds are just ‘closet’ trackers but with charges much higher than those of any tracker.

Every investor looking to beat the market consistently should avoid these funds - they can be dangerous.

The Best Way to Consistently Beat the Market

So we can see that index trackers are a smarter play than actively managed funds. However, there’s no need for you to settle for simply tracking the market. Because you have several advantages over the average fund manager that should enable you to beat the market. These advantages include the freedom to pick stocks from any sector and any market, right down to the smallest micro-cap. And you do not charge yourself any initial or annual fund charges.

You also have an advantage over the index fund because you can decide how much you invest in any single company. The index fund has to invest in proportion to the company’s market cap.

But of course, these advantages only give you better performance if you pick stocks wisely. There are a few simple rules to follow that will help in this. Of course, a company’s valuation needs to be reasonable to start with. But there are other important things to consider.

The first rule is to select companies with financial strength – look at the balance sheet and cash carefully. Secondly, make sure the company is growing profitably and has a leading market position in its niche. And thirdly, make sure that it is doing well in overseas markets as well as the UK – there is much more risk if a company is limited to the UK market.

But perhaps most importantly, the company also needs to have a sustainable edge in its market. This usually means it re-invests in its own future. Put another way, it is sufficiently profitable to be able to invest a sizeable chunk of its revenues in new products and services coming out of research and development. This kind of re-investment can have a dramatic positive impact on the share price down the line.

If you want to know more and learn about some of the keys to successful investment plus my investment allocation strategy come along on the 30th October. For more details and to book click here. I will share with you in detail how big my returns have been in the last 6 months, plus all the strategies i employ to grow my own wealth as a DIY investor.

Happy Investing and Reading!

Arun Mehra FCA �