5 Simple Ways To Beat The Market: Part 1 Of 5

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Summary

Stock ownership by U.S. households is low and falling even as the barriers to entering the market have been reduced.

Investors should understand simple and easy to implement strategies that have been shown to outperform the market over long time intervals.

The first of five strategies I will describe in a series of articles is the "size factor" that has seen small caps outperform large caps over time.

With today's article and four articles to follow over the next four business days, I will be showing readers five buy-and-hold approaches that have historically "beat the market," providing absolute and risk-adjusted returns in excess of the most commonly used domestic equity benchmark - the S&P 500. All of these articles have already been penned, and I will be asking Seeking Alpha readers to release the remaining four articles over the next four mornings (east coast U.S. time).

The improvement in the access to financial markets for the average investor over the trailing generation has been astounding. Thirty years ago, buying stocks often meant picking up your rotary phone and dialing your broker, paying him to often enter you into a front-loaded fund with an active manager seeking (and more often that not failing) to beat the market. Today, individual investors can access their discount brokerage via their smart phone to inexpensively purchase an index fund that replicates broad market benchmarks less miniscule tracking error and expenses.

Both then and now, the index that active managers have been trying to best is the S&P 500. Today, novice individual investors via low cost exchange traded funds like the SPDR S&P 500 ETF Trust (NYSEARCA:SPY) can essentially tie the market that we paid Wall Street experts so handsomely to try to beat. All it will cost is a trading commission less than or equal to the cost of a lunch, and an expense ratio of 0.095%, or $0.95 on $1,000.

The technological advances necessary for that transformation have been remarkable. One might expect that the reduction in the cost of financial intermediation would have improved the proportion of U.S. households with access to the stock market. They would be very mistaken. Stock ownership continues to fall.

Source: Federal Reserve Survey of Consumer Finances

Note: These figures are separate from retirement accounts, which were owned by 49.2% of American families, and also separate from pooled investment funds which were owned by 8.2% of families. These ownership levels are not mutually exclusive and most likely contain overlap.

Less that 14% of U.S. households directly own stocks, which is less than half of the amount of households that own dogs or cats, and less than half of the proportion of households that own guns. The percentage of households that directly own stocks is even less than the percentage of households that have Netflix or Hulu. Before I get comments that I am anti-gun, anti-puppy, or anti-binge TV watching, let me assure readers that I am none of those things. I am most certainly pro-stock ownership. From my lens, taking an ownership stake in the productive capabilities of American companies is both patriotic and simply good financial sense. Stock ownership has not recovered from the tech bust, and direct stock ownership has further diminished post-credit crisis even as the market has hit all-time new highs. The average American family has missed the stock market rally. Much has been made about the rising income inequality in our society. Those wishing to bridge the inequality divide should target financial literacy with an aim at increasing the percentage of families that glean the benefits of stock ownership.

The most fundamental reason I am back writing at Seeking Alpha is because our society on average is financially illiterate. Finance is both my profession and my passion, and I hope my articles can help better educate our readership. There are plenty of individual investors who would be well served with simply indexing market returns as I described previously. The barriers to entry into the financial market have never been lower or cheaper, and my financial advice for novices always begins with low cost diversification through index funds. If I could only write one article on this site, replicating the broader market in a low cost manner would be the focus.

On this portal, readers are "Seeking Alpha", or the ability to earn risk-adjusted returns in excess of the market. My articles implicitly assume that readers have decided that market returns are not sufficient for them, and have chosen to take active bets in an effort to outperform. This article describes the first of five buy-and-hold approaches that have outperformed the market over the trailing twenty years. These strategies are factor tilts from the broader market, and I will describe, supported by academic research, why I believe they have generated long-run alpha.

Size

The first factor tilt I will describe - the size factor - has been discussed in academic literature since Rolf Banz first described the size effect of equity returns in 1980. His work showed that smaller firms had higher average returns than larger firms in a forty year dataset. The size factor was memorialized in the Fama-French Three Factor Model published in 1982 that helped earn Eugene Fama the Nobel Prize in Economics last year. The Fama-French Three Factor Model observes that small-cap stocks tend to outperform large-cap stocks and low market-to-book stocks tend to outperform high market-to-book stocks. Adding these observations to the Capital Asset Pricing Model better describes stock market performance than beta alone. Beta is a financial measure of risk arising from general market movements. Since we are trying to beat the general market, it makes intuitive sense that alpha would be found in a size factor that was used as a supplement to better describe overall returns.

Our first way to beat the market, as proxied by the S&P 500, is then to simply buy smaller capitalization stocks. Below I have tabled the average returns of the S&P 600 Index, and show the returns of this index graphed against the S&P 500. This index is replicated through the iShares Core S&P Small-Cap ETF (NYSEARCA:IJR) with an expense ratio of 0.14%. (For the reasons why I have chosen the S&P Smallcap 600 over the more widely referenced Russell 2000, please see my article "The Small Cap Stock Index for You.") In the five strategies I am detailing to "beat the market", I will be using trailing 20 years of data, which is the longest time interval that encapsulated all of the relevant indices used in the analysis.

S&P Smallcap 600 vs. S&P 500 Index: Trailing 20 Years

Some readers might be reading this analysis, and dismiss the strategy as a way to beat the market. Simply taking more risk is not creating alpha. However, the small cap strategy has actually produced lower risk over the twenty year time period as measured by the standard deviation of annualized returns. A 1999 study published in the American Association of Individual Investors demonstrated that as you extended the holding period of small cap stocks that they exhibited less risk as measured by the minimum accumulation over time as compared to their large cap brethren. In the seventy-plus year dataset that AAII utilized, small cap stocks had a higher minimum accumulation as compared to large cap stocks in ninety percent of observations. For long-term investors with a buy-and-hold approach, the size factor has generated alpha over the recorded history of modern finance. Given the underperformance of small cap stocks relative to the market benchmark thus far in 2014 (-11.2% underperformance through the end of November), investors with a long time horizon may wish to shift some of their allocation towards smaller capitalization stocks in order to capture the "size factor" prospectively.

I will be publishing four additional proven buy-and-hold strategies that can be replicated through low cost indices over the next four days.

Disclaimer:

My articles may contain statements and projections that are forward-looking in nature, and therefore inherently subject to numerous risks, uncertainties and assumptions. While my articles focus on generating long-term risk-adjusted returns, investment decisions necessarily involve the risk of loss of principal. Individual investor circumstances vary significantly, and information gleaned from my articles should be applied to your own unique investment situation, objectives, risk tolerance, and investment horizon.

Disclosure: The author is long IJR, SPY.

The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.