Many individual investors believe that instead of hiring an advisor to help one manage their money, it is best for the individual investor to “do it yourself”, because the individual has a distinct set of advantages that can help outpace the market and even do better than professional money managers. One organization, the American Association of Individual Investors (AAII) was formed to help investors do just that. Its membership are some of the best and brightest individual investors in the country.
While many individual investors are extremely smart with high IQs, when they attempt to invest on their own, they tend to do worse than stock market averages for several reasons. They often attempt to move in and out of investments based upon their “gut feel” or opinions about the near-term future. Since in the short term, stock market movements are random they tend to get it wrong more than right. Additionally, most investors fall prey to their emotions – both fear and greed. Studies show that these emotions, not sound investment decision-making and processes often drive them in and out of various investments at exactly the wrong time.
Finally, the global stock and bond markets have become increasingly more efficient and the “information edge” that an individual could once exploit, has now largely been eroded. The individual or algorithm on the “other side of the trade” is generally much better equipped with the training, tools and software to make a better decision with respect to a particular security.
Decades of research has proven that a better way to invest over the long term (10 years or more) is to simply own through a portfolio of index funds, US, foreign and developing country equities and real estate and to rebalance this portfolio twice per year. Investment luminaries such as Professor Burton Malkiel of Princeton (who serves on my firm’s Investment Committee) and John Bogle, founder of The Vanguard Group have promoted this way of investing since the 1970’s. Portfolio indexing removes these sources of investment underperformance, simplifies the process and captures market averages. Investors who follow this process will outperform most individual and professional investors. Thus we believe our portfolio of broad index funds will outperform a portfolio managed by a sophisticated individual investor.
While a number of very smart people invest their own money, they are up against factors that often cause them to underperform the markets. At best, they are engaging in very expensive entertainment and at worst, gambling and jeopardizing a secure retirement.
Efficient market theorists have studied mutual fund performance over many years and have conclusively documented that the majority of actively managed mutual funds have been unable to outperform the market over ten years or longer. From this observation they conclude that markets are highly efficient and the best investment strategy is to simply buy index funds in order to match the performance of the markets and reduce fees and turnover expenses.
It is certainly true that mutual funds underperform the market. However, is it because markets are efficient, or that mutual funds managers trade too often and ignore the power of compounding dividends in their pursuit of capital gains?
I would like to construct a portfolio of high quality dividend paying stocks that that have a dividend yield and dividend growth rate greater than the market, reinvest the dividends over ten year period and see if such a portfolio outperforms the market.
I came up with this strategy by reading Jeremy Siegel's book "The Future for Investors". On page 243 he has a table showing the S&P 500 returned 11.18% per year between 1957-2003, where as a portfolio of the highest 20% yielding stocks in the S&P 500 returned 14.27% per year.
Perhaps if an individual investor follows a similar strategy they can outperform the market as well.
Each side will open and fund our own investment account just for this bet. When
trading opens on July 1st, the account balances will both be exactly $20,000. Both
parties will manage their accounts per their strategies, and neither party will
deposit or withdraw funds from the accounts over the 10 years. In 10 years, the
account with the largest account balance wins.