How Statistics Can Help You Beat The Market

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Includes: CMG, IJR, SPY, UNP, VNQ
by: Logan Kane
Summary

Understanding the underlying statistics and characteristics of stocks can help us build better-performing portfolios.

Stock-picking can work, but most investors are doing it the wrong way.

Understanding the effect that outliers have on your portfolio can help you avoid picking poor performers and tilt your portfolio towards winners.

ETFs are still underused by retail investors.

The way that most individual investors go about constructing their portfolio sets them up to underperform. Most investors know that the long-run average return of the stock market is around 10 percent per year depending on the time period you use. What most investors don't know is that a large percentage of the total return comes from a small percentage of the stocks. This is both a blessing and a curse for stock-picking.

For those who didn't read it, I'm starting with a brief recap of my piece "How Seeking Alpha Can Help You Beat The Market," which lays the foundation for some of the portfolio strategy that I'm about to detail. Roughly two-thirds of stocks end up underperforming the index, but one in seven stocks return over 20 percent annualized. If you're going to pick stocks, you simply can't pick average ones.

average return stocks

The takeaway that you should have here is that nearly two-thirds of stocks underperform the market (and by extension, the broad market ETFs, like the SPY.

The conventional wisdom is that the point of diversification is to avoid losing stocks dragging down your winners. The data, however, shows that most stocks are not big winners, and the winners are actually pulling up the losers. A more accurate statistical argument for investing in the broader market is that you ensure that you own enough winners to balance out the losers with enough left over for a nice return. Here's another graph outlining this.

annualized return stock market

Should you buy individual stocks?

The data clearly shows that the average stock does much worse than the market as a whole. However, the data also shows if you can correctly pick stocks, it's immensely rewarding. The top 14 percent of stocks return over 20 percent annualized over their lifetime. Based on the data, individual stocks are guilty until proven innocent. Unless there is a strong reason that a stock should outperform, you're going to be better off investing in broad market ETFs.

As a starting portfolio, I recommend putting 70 percent of your equity portfolio in the S&P 500 (SPY), 20 percent in small caps (IJR), and 10 percent in REITs (VNQ). If you like the prospects for a certain sector and want to go "overweight," Vanguard has a suite of low-cost quality ETFs that track each sector, like financials, tech, and energy. Sometimes owning individual stocks will be justified, however.

You should only invest in an individual stock when the additional reward of doing so is greater than the additional risk of concentrating your money in a single company.

We already know that we can achieve the index return without breaking a sweat by buying an ETF that tracks it, and additionally can get sector exposure by buying sector ETFs. That's the baseline return and there's no excuse for doing worse. Your job when adding individual stocks is to be very sure that the stocks that you're picking won't dilute the returns from the rest of your portfolio.

If you do feel you have a few strong theses and want to pick some stocks, cash in the ETFs proportionally and take somewhere between 1 and 4 stock positions in your best ideas, making sure that no single stock is over 10-15 percent of your portfolio as of your initial buy-in. For me, having fewer single stock holdings forces you to pick your best ideas and 10 percent is a reasonable starting position for a single stock holding.

Note: You might want to drop the 10-15 percent to 5-10 percent if your net worth is higher than 2-3 million bucks.

For example, if you want to own the market but also love Union Pacific (UNP), Boeing (BA), and Apple (AAPL), your equity portfolio would look like this.

10 percent AAPL, 10 percent BA, 10 percent UNP, 49 percent SPY, 14 percent IJR, 7 percent VNQ.

With this simple portfolio, you get the benefit of profiting from your investment theses being potentially proved right and the diversification of owning over 1200 stocks between the 3 ETFs.

Where stock-picking makes sense.

1. The consumer discretionary sector. Retail, fashion, and restaurants are good examples of where there's a huge gap in the performance of the average business and the exceptional. If you've ever had an amazing or terrible experience at a restaurant, then you should understand this intuitively. Let's look at a couple of case studies.

This is the graph of Chipotle (CMG) stock from 2007 to 2014. During this time, eating at Chipotle was an ongoing sociological phenomenon that became more and more popular. All you would have had to do is go to Chipotle back then, notice the popularity and that the food was pretty good, and you'd have $90,000 for every $10,000 you invested roughly 7 years earlier.

Chart CMG data by

YCharts

Now, if you're paying attention, you might have noticed a second trend around Chipotle over the last 4 years. Chipotle became far less beloved and the internet filled up with jokes about food poisoning there. The stock is down since then. Wall Street operates off of earnings estimates set by analysts but typically fails to understand the underlying sociological trends behind fashion and retail. The underlying trends tend to lead the earnings estimates by a few quarters. This gives us an advantage over Wall Street in selecting stocks.

Chart CMG data by

YCharts

Apple is another example of an ongoing sociological phenomenon that Wall Street underestimated. Apple is a technology company, but it's also a fashion company and has been since even before the iPhone. When the iPhone came out in 2007, everyone had to have one. The lines at Apple stores were out the door and in the 11 years since you'd be hard pressed to find an empty Apple store. Apple shareholders have made a mint since then.

Chart AAPL data by

YCharts

2. Companies with monopolistic market structure and attractive valuation.

The main reason that companies go out of business is competition. MySpace used to be one of the most visited websites on the internet, but now it isn't. However, companies like Union Pacific and Boeing dominate their respective industries. Where there are powerful barriers to entry, valuing stocks becomes easier and returns are more likely to fall within our models. This helps eliminate some of the ugly left tail in the red and green annualized return graph I showed you. If a company's business could be described as an oligopoly or monopoly, I am much more comfortable taking a single stock position in them.

I'm on the fence about whether individual securities are better for some other sectors. REITs, for example, I believe have a fair amount of return dispersion based on how good the management is. After all, all real estate is local, but interest rates are set on a national level. This means savvy investors will always be able to make money. That said, VNQ is a strong, safe investment with low correlation to the S&P 500 index. You are allowed to double dip and pick one if you find a REIT with an expected return better than both VNQ and SPY.

Also, this should be obvious, but don't invest in any single stocks in any sector with a lower expected return than the SPY. It won't justify the single stock risk. You can make a rough estimate of a stock's expected return by adding earnings yield (FFO yield for REITs) and expected earnings growth (make your own model or use analyst EPS estimates). If you run the numbers and they add to less than 10 percent, forget about the stock.

Where ETFs make sense.

Pretty much everywhere else.

Sector ETF exposure is a better play in most industries as the potential benefit from concentration does not outweigh the additional risk added to your portfolio. Typically, the damage that incompetent management can do far outweighs the benefit that intelligent management can provide. Any time you invest in a company rather than a sector, you take the additional risk that a company-specific factor spoils your thesis.

By investing in the shares of single stocks, you run the risk of things (depending on the industry) like class-action lawsuits, accounting issues, foreign governments expropriating assets, competitors oversupplying the market, management making boneheaded acquisitions, regulatory issues with agencies like the FDA or FTC, et cetera. The upside has to be strong enough to justify putting up with company-specific risks.

We know that roughly two-thirds of stocks underperform the underlying index, so use a very critical eye when evaluating risks.

You don't need to have a bank stock in your portfolio, or a technology company, or a REIT. Stick to ETFs and only buy individual stocks on your best ideas.

I'm comfortable taking single-stock risk in companies that have strong competitive moats, like Union Pacific and Boeing. Conversely, I am not typically comfortable taking this risk in high-multiple technology companies. There are a ton of young technology companies carrying high valuations, and they can't all be winners. It's a lot harder to predict which technology company will outcompete the rest than to predict that technology (or subsectors of technology) as a whole will perform well.

Apple is an exception because while technically a technology company, I view Apple as somewhat of a retailer/consumer/fashion company. The risk is that technology changes fast. A perfect thesis based on the information you had at the time can land you down 50+ percent in the span of a few months when the company you invested in finds their tech obsolete.

Often, we're unable to pick stocks that have a high enough return to justify the additional risk over simply owning the sector. This is okay because ETFs offer an effective way to get sector and market exposure. By focusing on our best ideas and not swinging at every pitch, we increase our odds of selecting stock picks from the roughly 14 percent that return over 20 percent annualized and adding to our returns rather than diluting them.

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Disclosure: I am/we are long SPY, VNQ, IJR. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.