Stop Trying To Beat The Averages

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Includes: CRUS, SPY, VRA, WGO
by: Backroom Analyst
Summary

The S&P 500 is often used as a benchmark to determine investment success. It is time to stop that.

Companies that have a market cap greater than $68 billion skew the data so much that the S&P 500 is unusable as an average.

It is suggested that one use different benchmarks to determine investment success.

"At any given time, only half of us are better than average."

When we allocate our portfolios, our success as managers is measured by whether we are able to beat the "Market". Usually, the "Market" is defined as the S&P 500, the index of 500 large U.S. companies. The methodology of the S&P 500 defines these companies as having a market cap of at least $5.3 billion, are profitable, and are fiscally viable. I often ask myself whether that is fair, or even necessary. I contend that it is neither

First, and foremost, the S&P 500 is not a representative sample of the U.S. stock market; not even close. When one runs the numbers (I used Zacks' stock screener to find the data, 2/5/2015), some simple facts come to light. The average market cap for the S&P 500 is either $38,113M (mean, σ = $21,290M) or $18,905M (median, IQR = $25,716M). Compare this to the total market averages $4,422B (mean, σ = $21,290M) or $253M (median, IQR = $1,717M). If one looks at the math correctly, the upper bound of the middle 50% of the total market does not even qualify to be large enough to be part of the S&P 500. The chart below shows these extreme differences in market caps:

What does this mean? Well, if one uses Tukey's Model for finding outliers, 311 members of the S&P 500 would be considered outliers in terms of size. In fact, 64 members of the S&P 500 would be considered extreme outliers. This means that at least 64 of these companies would have to be rejected from a sample population if one were looking for a "normal" group to determine an average. This is not too surprising. The S&P 500 makes up over 70% of the market capitalization of the U.S. stock markets. If one digs a little deeper, these outlier companies (listed below) are 37.6% of the total market cap in the U.S., and 52.7% of the S&P 500 itself. The data is so skewed that the seven largest U.S. companies, make up over 10% of the entire stock market (14.2% of the S&P index).

Ticker

Name

Market Cap ($USD mil)

AAPL

Apple Inc.

$ 696,606.60

XOM

Exxon Mobil Corp.

$ 384,223.47

BRK.B

Berkshire Hathaway Inc.

$ 363,546.66

GOOG

Google Inc.

$ 355,566.72

MSFT

Microsoft Corp.

$ 343,841.12

JNJ

Johnson & Johnson

$ 284,219.10

WMT

Wal-Mart Stores Inc.

$ 279,619.56

WFC

Wells Fargo & Co.

$ 274,183.60

GE

General Electric Co.

$ 242,619.36

PG

Procter & Gamble Co. (The)

$ 231,676.75

FB

Facebook Inc.

$ 211,537.11

JPM

JPMorgan Chase & Co.

$ 209,440.44

CVX

Chevron Corp.

$ 204,827.44

PFE

Pfizer Inc.

$ 202,062.08

VZ

Verizon Communications Inc.

$ 198,609.00

ORCL

Oracle Corp.

$ 186,563.16

KO

Coca-Cola Co. (The)

$ 182,350.00

T

AT&T Inc.

$ 178,484.67

DIS

Walt Disney Co. (The)

$ 172,176.00

AMZN

Amazon.com Inc.

$ 169,608.75

MRK

Merck & Co. Inc.

$ 168,932.78

BAC

Bank of America Corp.

$ 166,056.20

INTC

Intel Corp.

$ 163,195.19

V

Visa Inc.

$ 163,162.98

IBM

International Business Machines Corp.

$ 155,547.36

GILD

Gilead Sciences Inc.

$ 148,982.97

CMCSA

Comcast Corp.

$ 146,591.31

C

Citigroup Inc.

$ 146,356.77

PEP

PepsiCo Inc.

$ 145,189.80

HD

Home Depot Inc. (The)

$ 142,884.39

CSCO

Cisco Systems Inc.

$ 136,359.22

PM

Philip Morris International Inc.

$ 127,713.12

CVS

CVS Health Corp.

$ 115,830.38

AMGN

Amgen Inc.

$ 115,102.00

QCOM

QUALCOMM Inc.

$ 110,751.84

SLB

Schlumberger Ltd.

$ 107,827.63

UTX

United Technologies Corp.

$ 107,384.20

UNP

Union Pacific Corp.

$ 107,298.07

MO

Altria Group Inc.

$ 106,818.01

MMM

3M Co.

$ 104,676.60

BA

Boeing Co.

$ 104,044.35

UNH

UnitedHealth Group Inc.

$ 103,819.04

BMY

Bristol-Myers Squibb Co.

$ 98,279.16

MA

MasterCard Inc.

$ 97,022.67

CELG

Celgene Corp.

$ 93,256.00

BIIB

Biogen Idec Inc.

$ 92,364.95

MCD

McDonald's Corp.

$ 91,529.46

UPS

United Parcel Service Inc.

$ 91,281.24

ABBV

AbbVie Inc.

$ 90,672.77

AXP

American Express Co.

$ 85,533.03

COP

ConocoPhillips

$ 81,080.24

GS

Goldman Sachs Group Inc. (The)

$ 80,719.17

NKE

Nike Inc.

$ 79,954.56

HON

Honeywell International Inc.

$ 78,868.11

USB

U.S. Bancorp

$ 77,833.88

FOXA

Twenty-First Century Fox Inc.

$ 75,346.68

LLY

Eli Lilly and Co.

$ 74,674.06

MDT

Medtronic PLC

$ 72,647.40

AIG

American International Group Inc.

$ 72,308.34

WBA

Walgreens Boots Alliance Inc.

$ 70,611.09

ACT

Actavis PLC

$ 70,524.33

HPQ

Hewlett-Packard Co.

$ 69,709.02

LOW

Lowe's Cos Inc.

$ 68,832.58

COST

Costco Wholesale Corp.

$ 68,682.60

So what is the problem? It's simple. We establish a portfolio, and want an accurate measure to see if we are successful in our money management. To do this, we compete against extreme outliers, and then expect to beat the market at least 50% of the time to be considered successful. If we cannot do that, then we are supposed to give up, and just use index funds to achieve our monetary goals. This is wrong. This is like comparing random IQ scores to a group of Mensans. Some will be successful. Most, around 97.5%, will fail.

What is the solution? First, more appropriate indices are the Global Total Market Index or the Wilshire 5000. For the past ten years, the Total World Market Index has averaged 3.1%, the Wilshire 5000 has averaged around 7.4%, and the S&P 500 during this time averaged 7.8%. Second, maybe one should consider some different numbers to beat. Here are a few.

0% is a good number to beat. It is the ability to earn a positive return over time. I have met many investors who will tell me that they don't care about beating the market. They just do not want to lose money. There is nothing wrong with that. If they had indexed to the S&P 500 or the Wilshire 5000, they would have lost over 37% in 2008, and that is simply not acceptable for them. They do not want to hear about beating the market. The want to hear that they will make money over time, without a lot of downside risks.

3.2% is another good number to beat. That is the average rate of inflation since 1913. Inflation is the ultimate enemy when it comes to investing. If we cannot beat inflation, then we are losing the real value of our dollars, and are moving backwards. If we invest $10,000 today, it needs to grow to at least $18,757 in 20 years just to have the same spending power.

The last number to consider is 4.7%. According to data since 1871, that is the average return on U.S. Treasuries. It is called the "risk free" return. If one's investment strategy cannot beat that margin, then s/he is losing compared to a guaranteed return.

Here is the irony of all of this. I ran a backtest of the stocks that have a market cap less than $2 billion. To stay consistent with some investing philsophies I have adopted over the years, such as GARP and bulletproofing, I added those to narrow the field. The results are interesting.

Averaging about 16 stocks per period from value line, the average return of this small cap strategy was 9.98% (σ = 32.72). This beats the S&P's annual average (7.45%) during this period by 253 basis points per year. The profit/loss ratio is a nice 1.84, too. Some of the stocks that make this cut are Winnebago (NYSE:WGO), Vera Bradley (NASDAQ:VRA), and Cirrus Logic (NASDAQ:CRUS).

We all want to be successful as investors. The contention here, and always, that we all have our own personal benchmarks that make us comfortable with our investment decisions. It is called risk tolerance, and in relation to our needs, it needs to have an appropriate suitability. I know there will be those who will disagree, but all of this allows one to have total control over their investments, and not worry about beating an arbitrary number that actually has little meaning.

Happy Investing.

Disclosure: The author is long QCOM, WGO, VRA, CRUS. 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.