How to Beat the Market

Beating the market is hard to pull off. Hotshot money managers may do it for a while, until they fall short. But odds are better if you mix good growth and good income equities, 60-40.

Of course, no asset allocation is foolproof, and past performance never guarantees future results. Still, this 60-40 approach performed twice as well as the market over the past decade, and is worth a look.

Over the last 10 years, investors endured a major bear market, a serious recession and a financial crisis – unrivaled since the 1930s. The Standard and Poor’s 500 delivered a subpar annualized total rate of return (appreciation plus dividends) of 6.34% over the decade ending July 31. Many investors fared far worse as the emotional pressure made them sell all their stocks at or near the lows of 2008-2009. Fear kept them from exploiting the greater-than 100% run since the lows of March 2009.  

Many investors ask us: “What can I do? I don’t want the stability of bonds because there’s little upside and higher interest rates eventually will kill them. But the stock market is too scary.”

That’s where the 60-40 allocation comes in. This hybrid approach combines the lower risk attributes of income-producing equities with the risk of growth stocks. It is a framework that helps an investor to sensibly bear the risk needed to achieve reasonable returns.

For over 10 years, my firm has used this allocation. We shifted some over the years to exploit market anomalies, but have on average maintained the following mix:

·         60% equities, divided roughly equally among indexes for large, small and midcap stocks.

·         40% master limited partnerships, which produce distribution yields (meaning income) in excess of 6% per year.

This approach is very practical for the individual investor. You can purchase low-cost exchange traded funds, which strive to closely mirror the performance of each index. The three indexes capture different segments of the market. Midcaps did the best over the past 10 years. MLPs, focused on energy and represented by the Alerian Total Return Index, must give most of their earnings to investors through distributions, a.k.a. dividends.  As I explained in my last article, MLPs did very well over the past decade.  

To see how this asset allocation fared over the last 10 years from a return and risk perspective, examine the tables below:

Beta gauges an asset’s volatility compared to a benchmark (here, the S&P 500). A 0.00 beta tells us its returns had no relationship to the market; 1.00 means it matched the S&P 500 exactly. In the above table, the 60-40 mix’s beta was less than the S&P 500.

Upside capture is how the 60-40 allocation did in up markets. At 105.3, it outpaced the S&P. In a down market, known as downside capture, our allocation dropped  less than the benchmark.

The returns generated from this approach were excellent and, surprisingly, risk was considerably below that of the S&P 500. What’s less apparent and probably the greatest benefit of this 60-40 allocation is psychological in nature.

Human beings are emotional. In the realm of investments, we pay a high price when we accommodate our emotions – often selling when the market tanks, when we should stay invested for the eventual rebound.  Having a 40% commitment to income securities gives an investor the courage and staying power to bear the risk and volatility of equities. It guards against doing the wrong thing at the wrong time.

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Ben Niedermeyer, CFA, is a partner with Taylor Investment Counselors in Boston

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