It’s Easy to Beat the Market – But Even Easier to Fool Yourself

In an interesting piece of research by Joel Dickson from exchange-traded fund pioneer Vanguard, he found an easy way to beat the American share market index, the S&P 500. He had grouped every company into the index according to the first letter of their ticker symbols; for instance, Apple and Activision Blizzard, with their ticker symbols of AAPL and ATVI respectively, would be in the same group.

Next, he constructed 26 equal-weighted portfolios from the 26 groups of companies (there are 26 alphabets in the English language) and rebalanced them monthly. The results are pretty staggering – the alphabet-soup of portfolios had all trounced the market from the end of 1994 to October 2013.

But, you won’t see Vanguard build any ETF products based on such rules. That’s because Dickson’s research was meant to be satirical even though the math was real.

Yes, his portfolios did beat the market – but the reason wasn’t because of the alphabetical-grouping. The reason for outperformance had likely to do with how the portfolios were equally-weighted, unlike the market-capitalisation-weighted S&P 500; much like our Straits Times Index (SGX: ^STI), the weightings of the constituents in the S&P 500 are arranged in general accordance to their respective market capitalisations.

As written by investment strategist James Montier of GMO, an investment firm with US$117 billion of assets under management, when you take away the focus on market-caps when you construct a portfolio of shares, “such a process essentially guarantees there will be a value and a small cap tilt to the portfolio.” And, historical evidence of the good performance that can come from buying small-cap shares and cheap shares are aplenty.

In light of that, it’s easy to see how Dickson’s alphabet-portfolios of shares could do better than the index – it’s likely that those portfolios had a small tilt toward value and small cap shares due to the equal-weighted nature of the portfolios.

Although the mystery behind Dickson’s satirical market-beating portfolio has been lifted, there’s still a very important point hiding underneath.

The modern world is drowning in data and the financial markets would have its fair share of that abundance. “Given long enough time and deep enough data,” wrote renowned financial journalist Jason Zweig recently in the Wall Street Journal, “you can find a seemingly impressive linkage between almost any two factors. But correlation isn’t causation.” When causation is missing, we can’t count on the correlation to continue.

It can be just a matter of trawling historical data to find some ‘market-beating’ strategy that has shown impressive results after extensive back-testing. But again, that could be purely correlation without any hint of causation. So, like Jason Zweig cautions, “If you don’t ask questions about performance that was plucked out of the past, you are likely to end up disappointed about the returns you get in the future.” In other words, if hard questions aren’t asked about how a back-tested investment strategy has managed to perform well, it’s easy to fool (small “f” foolish) yourself into thinking that its historically strong performance can continue.

As for what’s some of the strongest causations one can find in the share market? Well, the phenomenon of a share’s performance being tethered to its underlying corporate performance would have to belong to that category.

There are reasons for stocks to go up,” investing legend Peter Lynch once said in 1994. “This is very magic; it’s a very magic number, easy to remember. Coca-cola is earning 30 times per share what they did 32 years ago; the stock has gone up 30 fold. Bethlehem Steel is earning less than they did 30 years ago – the stock is half its price 30 years ago. Stocks are not lottery tickets. There’s a company behind every stock – if the company does well, the stock does well. It’s not that complicated.”

I think Lynch’s words are incredibly wise. What about you? Share your thoughts in the comments-section below!

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The information provided is for general information purposes only and is not intended to be personalised investment or financial advice. Motley Fool Singapore writer Chong Ser Jing owns shares in Apple and Activision Blizzard.