How to Beat the Pros at Common Stock Investing

It is not hard to outperform the average professional investor, if you define "average" as the combined group of mutual fund managers, hedge fund managers, and sell-side brokers operating discretionary accounts. Because this recipe is short and easy to do, this will be a short article.

What is the Average Return?

There are so many professional investors that the average gross performance of managed investments is the market average return. As a large group the professionals cannot help but be average overall. 

Unfortunately for customers, the net return on their investments is reduced from the average, on average over all managers, by the average fees charged by the professional investment managers. These can range from 0.05% for index funds to 1.0% for smaller and specialized mutual funds, to 2% or more for specialized hedge funds. Even for famous mutual fund companies that are well-known to 401(k) participants the fees charged by their actively managed funds may be 0.3% to 0.9%, annually.

What is the average market return? Using the figures produced by SBBI, large cap stocks return about 10% annually, small caps 12% annually. Most professionals that are known are running larger amounts of money, and generally must trade in at least some large cap stocks, so returns (still on average, remember) will be a blend of 10% and 12%, and with some cash always held aside for redemptions or moving between investments, the average return will tend toward 10% or even slightly below. 

Your Strategy

As an independent investor, your strategy to beat those returns involves these steps:

1. Invest in a small cap index fund with a low fee (perhaps 0.05% to 0.15%)
2. Stay fully invested

Your long range rate of return will then be just under 12%, which will beat the average pro's return of just under 10%. You may have intermediate results that are more volatile, but over longer periods the volatility will work in your favor if you add money periodically, as you will be dollar cost averaging.

You may be wondering whether it is possible to improve on the average by market timing. The answer is a strong "not really." Academic papers showed over 30 years ago that at most 2% of investment performance depends on timing, so on average the pros could at most move their 10% large cap returns to 10.2%. The advantage remains with the small caps, and with the low fees of index funds. 

QED