I'll Beat the Market Yet

For a few glorious moments the other day, the total return since inception of my Practical Investing portfolio surpassed that of its benchmark, Vanguard Total Stock Market ETF (symbol VTI). However, a few days later, after a run of market gains, the index fund was back in front. And that’s the way it goes. The portfolio, which I launched in October 2011, typically lags on days when the market rises sharply and leads on days when the market stumbles.

This nip-and-tuck race spurred a reader to ask whether the portfolio had failed to live up to its goal of beating its benchmark over the long haul. “Would we all be better off simply investing in index funds?” the reader asked. The honest answer is that it’s too soon to say; we won’t know for sure until we experience a significant decline in share prices. And that hasn’t happened since I embarked on this project (see How to Survive a Stock Market Correction).

First, let me say up front that I like index funds. They’re a low-cost way to match the market. I’ll also confess that I don’t invest in individual stocks with the expectation that I’ll beat the market when stocks are charging ahead. When that’s happening, I’m pretty happy just to keep up.

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The real aim of my venture into individual stocks is to prevail when the market plunges or languishes for years. As wonderful as the Vanguard exchange-traded fund is at providing a broadly diversified basket of stocks, it falls short when it comes to controlling risk, as, frankly, most index funds do.

Index funds flunk Risk Management 101 for three reasons. First, index funds don’t hold cash. They buy all the securities in the index they track, and they remain fully invested at all times, whether stocks are cheap or expensive. I, on the other hand, hold more cash when stock prices look dear. Right now, I have about 7% of the portfolio’s assets in a money market fund.

Second, big companies tend to dominate broad-market index funds. That’s because traditional index funds are weighted by market capitalization. The bigger a com­pany’s value on Wall Street, the bigger its share of the index. Thus, even though the Total Market fund owns 3,684 stocks, the five biggest holdings account for almost 9% of its assets. Overall, 72% of the ETF is invested in the shares of large companies, according to fund tracker Morningstar.

A better mix. Large companies are arguably more stable than small ones. But I think Total Market is too concentrated in big-cap stocks. My portfolio is more evenly divided among big, small and midsize enterprises.

Most important, my portfolio lets me be picky about the stocks I hold. That’s something index funds can’t do. An index fund must invest via formula. It can’t ask: Do I understand the business a particular company is in and the prospects for its industry? Do I like the firm’s leaders and the direction they’re taking? Do I believe the company is generating enough cash to keep paying its dividend and, better yet, boost it?

And the kicker: Are the shares simply too expensive for my taste? Some critics of index funds say that the traditional formula of weighting companies by market cap results in the funds becoming overloaded with stocks that have become overpriced. The more expensive an Apple or an ExxonMobil becomes, for example, the greater its market cap and the greater its weight in the index. I’m happy to say that the shares in my portfolio are a little less expensive than the shares in the index fund, and my stocks boast a better yield.

Will these risk-management steps protect the portfolio in a downturn or allow it to outperform the market when it stagnates? I hope so, but only time and a less exuberant market will tell.