The winning strategy is: do nothing
Saturday 02 November 1996
This trust was first set up in 1935. Its objective was to hold 30 shares. The only investment criterion was that they should be leaders in their industries at the time. The number of shares the trust bought was exactly the same for each company, regardless of the price. And just to make the job of running the portfolio even easier, the trustees were forbidden to change the shares to account for the fluctuating fortunes of the companies they originally selected.
You could not, in other words, find an investment method that was any simpler or - seemingly - less rational. Many investors, we know, tend to overtrade, but leaving a portfolio completely immune to anything that happens in the outside world seems to be taking the principle of passive investing too far.
Yet guess what? Over the last 20 years, this do-nothing portfolio, which now holds only 23 shares, has consistently outperformed the main US market index, the S&P 500. And what is more, the trust has beaten all but 15 per cent of conventionally managed funds in the US.
Luck or judgment? Mr O'Shaughnessy has no doubts. His conclusion reinforces the view that most active investment strategies simply do not deliver what they promise. No fewer than 80 per cent of mutual funds (the US equivalent of our unit trusts) fail to beat the market index over any reasonable time frame.
It is no surprise, in the circumstances, that indexing - buying a fund whose objective is simply to match the overall movement of the stock market - is becoming increasingly popular, especially with institutional investors. In the United States, the amount of money managed this way grew from $10bn in 1980 to $250bn a decade later. (You may have seen that BZW, the UK investment bank, which is the market leader in the field, says in future it will do no active fund management at all.)
What makes Mr O'Shaughnessy's conclusion important is the wealth of data that lies behind it. He is the first researcher to have been given access to Standard & Poor's entire database of stock market prices stretching back 43 years. The power of modern computing means he has been able to crunch these numbers to find out, in a systematic way, which kind of shares - and which type of stock selection methods - have done best over that period.
For those who like numbers, the result is a statistical treat. There is not space to do justice to all Mr O'Shaughnessy's findings, but here are just a few, to give a flavour:
The surest and most consistent way to lose money over time is to buy the most popular shares in the market - ie those with the highest p/e ratios, or lowest dividend yield, and so on. High p/e ratios are particularly dangerous. The stocks with the highest p/e ratios underperform the market nearly 90 per cent of the time.
The value indicator that works best over time is the price to sales ratio. (This, ironically, is one indicator which is rarely used on this side of the Atlantic by stock market analysts). Shares selected on the basis that they have the lowest price to sales ratio consistently outperform the market.
Generally speaking, picking shares on a "value" basis is better than hunting for "growth" shares, but the best strategies combine the best of both methods. Relative strength (how shares have performed relative to the market in the most recent past) is an important component of nearly all the most successful strategies over time.
Of scores of different strategies studied, a mixed strategy, half in large stocks with high dividend yields and the other half in smaller companies with persistent earnings gains, low price to sales ratios and good relative strength provided the best and most consistent returns after adjusting for risk.
But as with the Lexington Corporate Leaders trust, it is the implications that are most important. Not for nothing have fund managers and stockbrokers been awaiting his results with some trepidation. The findings are a pretty devastating indictment of active fund management techniques that underlie the industry's central marketing proposition.
But of course, as with so many things, investors only get what they themselves ultimately want. Mr O'Shaughnessy's conclusion on the fallibility of the individual investor is also severe, but equally incontrovertible.
"Successful investing runs contrary to human nature" he concludes. "We make the simple complex, follow the crowd, fall in love with the story, let the emotions dictate decisions, buy and sell on tips and hunches, and approach each investment decision on a case-by-case basis, with no underlying consistency or strategy."
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