Can Individuals Beat Mutual Funds?

How High is the Bar With Beating the Market?

The bar in which mutual funds are measured by is generally the S&P 500 stock index, which is deemed to be representative of the U.S. stock market. The U.S. stock market is the largest in the world, and this comprises the main focus of stock based mutual funds, even though they may invest in stocks in other countries as well.

The goal of any mutual fund manager is to at least match the S&P, and preferably beat it. This is what they get paid the big bucks for, and charge higher management fees for. Otherwise, investors could just buy index funds, which will come close to the performance of the market by design, since they look to mirror it.

With the fact that most actively mutual funds fail in even keeping up with the market, and these fund managers have knowledge, skill, and resources that far surpass everyday investors, what chance do individuals have to beat the market and beat these funds?

This is the thinking that has most investors not even contemplating such a feat, let alone attempting it. Given that these investors don’t really have much of a clue about how to pull off any of this, that’s probably a good idea, as there is some knowledge and skill that must be put to work in order to beat the performance of these funds, but it’s actually pretty modest.

With a modest degree of effort and a minimal level of skill, and especially if we can rid ourselves of the myths that most investors find themselves in the grip of, it’s actually quite easy to significantly outperform the market.

Speed Matters

Individual investors have a number of huge advantages over mutual fund managers that can be leveraged. The first is advantages of scale.

Mutual funds trade in huge lots of shares, the sort of size that you can’t just click your way in and out of, and it can take weeks for them to enter or exit positions. This makes trading stocks much more challenging.

The main difference between just putting an order in for a security and having to scale in and out over time is the amount of slippage that scaling involves. Individuals do experience a bit of slippage, where you may pay a little more than you hoped or may get a little less when you are selling, but this is nothing compared to having to scale your trades over days or weeks.

If we imagine the price of a stock rising, maybe you have to pay a few cents per share in the moment from when you place your order and you are filled, mere seconds. If you are trading a million shares though, it can move much more than this over a period of days or weeks and you can end up paying quite a bit more or getting quite a bit less than you hoped when the decision to place the trade was made.

Institutional traders do use some pretty slick tactics when trading, but these often taking more risk, for instance when they trade against the trend, looking to buy when something is going down or sell when it’s going up. This is to some extent needed but it does add risk to the trades to be sure, as well as hindering performance.

Mutual funds are like ocean freighters, it takes a long time to turn them around, where individuals are more like speed boats, being able to turn around positions on a dime. This is a very big advantage indeed for individuals and a huge disadvantage for mutual fund managers.

Mutual Funds are Long Only

Mutual funds are committed by regulation to only take long positions, and also to be almost fully invested. This is great during bull markets, as this is exactly what you want, to be fully long, meaning that you are buying securities and betting they will increase in value.

However, this is a disastrous during bear markets, as this is the exact opposite of what you should be doing, and at the very least this is the time that we want to not be betting that the price will go up. Prices are going down after all, and while there aren’t many investors who are comfortable shorting, or betting things will go down, at least by being out of the market you are sparing yourself of the pain that the long investors are forced to bear.

The investment industry has done a fabulous job of scaring people away from shorting, at least those who invest in stocks, although there isn’t really anything different from being long or short, other than the direction of your stake.

While shorting in a longer term time frame, as most investors prefer, does need to be done with care, ensuring that you aren’t holding short positions during longer term bear markets, this isn’t that hard to do and the scare tactics that are used are only really applicable to those who manage their portfolios rather foolishly. While bull markets tend to be of a longer duration, we still see fairly long bear markets as well, and a pullback of a couple of years is plenty long enough to take well advantage of if one is willing and prepared to do so.

You can’t go short with mutual funds though, but you can buy inverse exchange traded funds or sell short regular ETFs, which allow people to play the other side of the market as desired.

Even if an investor is unwilling to bet that the stock market will go down, at the very least they have the ability to invest their money elsewhere during these market declines. Even using some very simple technical indicators such as longer term moving averages have produced results that have significantly outperformed the market, strategies that are so easy to follow that a child could do it.

Isn’t The Best Method To Just Hold Over Time Though?

Mutual fund dealers want you to believe that anything other than buying and holding is the wrong way to invest and will just get you in trouble. The more mutual fund companies can convince us that this is the only right approach, the more likely we’ll buy their mutual funds and not try anything else, so they do have a vested interest in this to be sure.

There are plenty of investors who end up thinking that managing your own portfolio is easy, and then manage to screw things up pretty badly. Stock picking is one of those ways, and this can lead to spreading one’s portfolio over a few stocks.

The real reason why this strategy isn’t a good one isn’t even the lack of diversity, even though it’s a little better to be more diversified, it’s that the stock selection itself tends to be poor. People will, for instance, focus on hot stocks, ones that have already run up quite a bit, stocks that are primed for a pullback, and may get a rude surprise as they consolidate and others take profits.

Stock selection really needs to be left up to the mutual fund managers, and even then, one should stay away from actively managed funds that select stocks and stick to index funds. Simpler is often better, and many extremely skilled professional traders stay away from picking stocks and stick to playing the market as a whole.

Not knowing what you are doing is another big pitfall among budding stock investors, and if you’re going to trade your own account, you will need to have a good idea of how to do this properly. This is not about following tips or hunches. People who trade on hunches are at best trading on luck, although in many cases it’s worse than that, as they will tend to make all sorts of mistakes that add to their problems.

The Correct Way to Manage Your Mutual Fund Investments

Markets are all about momentum, and momentum is what makes investing profitable. Over time, there is a positive momentum, meaning that over the long haul people tend to put more money into the market than they take out, and this will drive prices up by increasing demand over a given amount of supply.

Investing really is about very simple economics, and the reason why prices go up is that demand is increasing, and the reason they go down is because demand wanes. If people are investing in the stock market more, it goes up, if they pull money out on a net basis, it goes down.

In order to beat the market, assuming we have no inherent disadvantages such as mutual fund managers do, we want to be long the market when the momentum of demand is increasing, and not be in it when the reverse is going on.

If people are selling off and exiting the market, there is no good reason why we should not join them, provided that this selling is significant enough. The suckers get left behind, and this is not the group we want to be in. It is not hard to tell what sort of market we’re in, and if you just ask someone on the street, they will often have a good idea of whether we are in a bull or bear market.

If you hold your mutual funds when the momentum of the market matches the strategy of the funds, which is to take advantage of bull markets, and you move out of them when the market behaves in a way in which the mutual fund holding will be disadvantaged, during bear markets, it is pretty easy to beat the market significantly.

That’s really all there is to it, to be long with mutual funds or whatever else you’re looking to be long with when the going is good, and when a lot of people are heading for the exits, fleeing the market, making sure you are doing the same thing.

Regulators have a bias toward the long side, they want people buying and holding and especially not shorting, and while they may want us to think that this is to do with business stability, that’s a big myth, other than of course those who hang on during big declines being disadvantaged.

Should we not wish to join them, there’s nothing saying we need to. If we feel particularly adventurous, we can even bet the other way and look to make money during bear markets, like the hedge funds do, only we have the ability to move much faster than they can and can easily outperform them as well if we’re up for it and are willing to put a little effort into doing so.