Efficient markets theory says it can’t be done, but…

A Simple Investing Method that Beat the S&P 500 for 17 Years (and Counting)

All it takes is a bit of knowledge and Morningstar…

In the past 27 years I went from a complete novice in all things investing to a reasonably good understanding of the topic, though I’d hesitate to call myself an expert.

I started out investing in mutual funds in 1992. As I learned more about the topic, my investments did fairly well, and I started to gain confidence.

Bad Things Happen When Confidence Outstrips Expertise

About 15 years ago I sold my house and had some cash to invest. Being over-confident in my investing knowledge due to the good results I had with my fund picks, I thought I could pick individual stocks too.

Luckily, I was smart enough to limit this experiment to a small fraction of my portfolio.

Things looked good for more than a year. My picks kept up with the S&P 500 index, even edging it out at times.

Then the bottom fell out of the market. One of my picks, shares of a large bank that paid a rich dividend, lost 90% in a painful two years. Ouch!

The rest of my picks did better, some really well. But my experimental portfolio still under-performed the S&P 500 index by a wide margin.

I sold my individual stock picks next time I needed some money.

I learned my lesson.

Professionals are called that for a reason, and mutual fund managers are pros.

Professionals are called that for a reason, and mutual fund managers are pros

Good mutual fund managers have a lot going for them — far more investment experience and knowledge than you or I will ever have; no other full-time job or business to distract them; and the support of a deep bench of analysts.

Even with all those advantages, few managers boast a long-term track record of beating the overall market.

Find those few, and you can beat the market too.

Few mutual fund managers can boast a long-term track record of beating the overall market — but find those few and you can beat the market too

Pssst! Want to Know a Secret? Here’s My Simple 7-Criterion Investing “Secret”

Having learned my painful lesson about the challenges of picking individual stocks, I concentrated on a simpler arena to master. Mutual funds.

As a result, my average annualized personal rate of return in the past 17 years ended up more than 2% ahead of the S&P 500, and I’m happy to share how I did this. It’s a fairly simple method to implement, if not necessarily easy.

It boils down to this. I invest in mutual funds with the following 7 characteristics.

• No sales load — research shows that sales loads don’t lead to better performance before accounting for the load, and under-perform after accounting for it
• Lower-than-average expense ratios — every dollar in fees is a dollar that’s not performing for you
• Lower-than-average investment turnover — high turnover increases trading expenses and taxes, and if the fund advisor can’t find investments that can continue to perform well for more than a couple of months, their philosophy is too different than mine for my comfort
• Experienced manager or management team with solid long-track performance — anyone can get lucky for a year or three, but a manager who over-performs over a couple of up/down cycles is more likely to do well in the future (note that I said more likely, not guaranteed!)
• Shareholder-friendly governance — after getting burned by a fund that failed this critical test, I learned just how important this one is
• Morningstar Mutual Funds risk-adjusted rating of 4 or 5 stars — juicing returns by taking on crazy risk can work in the short term, but over the long haul the odds will get you — that’s why Morningstar considers performance on a risk-adjusted basis, and their best ratings go to funds that over-perform relative to their risk level
• Heavily weighted toward equities — in the long run, equities have far out-performed bonds, let alone cash; that’s why until I’m closer to retirement, I believe equities offer a better investing avenue

Next, unless I need money to cover expenses, I don’t sell investments no matter how the market fares, what other investors do, or what pundits say.

Unless I need money to cover expenses, I don’t sell investments no matter how the market fares, what other investors do, or what pundits say

As reported by Business Insider, an internal study conducted by Fidelity showed that Fidelity investors who did best with their investments had something in common — they had forgotten that they had a Fidelity account! The others kept trying to time the market, which is intrinsically a losing proposition.

Why Mutual Funds and Why I Might Do It Differently If I Started over Today

Picking the right mutual funds may let you outperform the overall market, as my anecdotal experience shows. However, mutual funds aren’t a perfect vehicle.

• They’re required to hold at least some cash to cover shareholder redemption requests, so they’re not 100% invested
• They’re required to distribute their realized capital gains, dividends, and interest to shareholders each year, so if they’re actively managed, they trigger a tax bill for shares held in taxable accounts
• If actively managed, they give rise to trading costs that grow higher with their turnover rate

If I started over today, I might invest in Exchange Traded Funds (ETFs) instead.

These don’t need to worry about redemptions — shareholders simply sell ETF shares to other investors. They also don’t have to annually distribute gains and income. That way you’re only taxed on your own realized gains and dividend/interest income.

The Bottom Line

Unless you’re an investment pro (and possibly even then), picking individual stocks is riskier than picking strong mutual funds or ETFs. Using the above 7 criteria to pick mutual funds, my personal rate of return over the past 17 years solidly outperformed the S&P 500.

Despite my performance results, if I was to start over today, I’d probably invest via ETFs, at least for my taxable portfolio.

Disclaimer

This article is intended for informational purposes only, and should not be considered financial advice. You should consult a financial professional before making any major financial decisions.

About the Author

Opher Ganel has set up several successful small businesses, including a consulting practice supporting NASA and government contractors. His most recent venture is a financial strategy service for independent professionals. You can connect with him there, or by following his Medium publication, Financial Strategy.