To close out this weekend, here is the latest from the AAII with a succinct list of the advantages that disciplined individual investors have over institutions. Hope everyone enjoyed all the sunny weather we had this weekend.
Five Key Markers Pointing to Successful Stock Investing
Certain factors put institutional investors at a disadvantage to a disciplined individual investor who follows a consistent, well-defined approach to investing.
- Consistently following an evidence-based approach for managing your stock portfolio helps maximize your opportunities to outperform
- Individual investor advantages over the professionals include access to overlooked stocks and the ability to maintain long-term focus
- Having clear buy and sell rules and the ability to stick with a strategy are crucial to investing success
AAII founder James Cloonan had two critical investment management rules. Rule #1 was: Develop a consistent, well-defined approach to investing in stocks. Rule #2 was: Stick to rule #1.
Cloonan further believed individual investors have advantages over institutional investors. Those advantages include the ability to invest in exchange-traded stocks of all sizes and being able to stick with long-term strategies. The first allows individual investors to invest in stocks overlooked by Wall Street. Such stocks are more likely to be mispriced (Figure 1). The second refers to the ability of individual investors to look past short-term bouts of downside volatility and underperformance as they build long-term wealth.
Cloonan’s rules and beliefs continue to underpin the broader philosophy followed by AAII. We believe investors maximize their opportunities to achieve investing success by consistently following evidence-based approaches for managing their stock portfolios. We further believe individual investors fare best when they make use of their advantages to consider all exchange-traded stocks and invest with a long-term focus.
Professional fund and portfolio managers are well aware of these advantages. They have significantly less freedom to invest in a variety of stocks because of the investment objectives they must follow and the sheer amount of money they are managing. At the same time, professional fund and money managers are frequently judged on their performance relative to their peers over shorter periods such as three years. This causes them to be concerned with how they are performing relative to their peers and makes it difficult to follow long-term strategies that have historically realized higher rates of return.
Combined, these factors put institutional investors at a disadvantage to a disciplined individual investor who follows a consistent, well-defined approach to stock investing.
Characteristics of Successful Approaches to Stock Investing
We at AAII believe that five key characteristics go into a consistent, well-defined approach to stock investing. Those characteristics are:
- It is evidence-based;
- The rules of when to buy and sell are clear;
- The strategy is quantitatively driven;
- If it is an active approach, it doesn’t look like the market; and
- You have the resolve and ability to stick with it over a long period of time.
Evidence-Based Strategies
An evidence-based strategy uses academic and/or industry research. It frequently has an economic reason and a behavioral reason that make it work. Backtested results further support it.
AAII’s Model Shadow Stock Portfolio is a good example of an evidence-based approach to investing. The portfolio’s roots can be tied to two key research papers.
The first was Rolf Banz’s 1981 Journal of Financial Economics paper, “The Relationship Between Return and Market Value of Common Stocks.” This study is credited with identifying the small-cap premium, which is the higher risk-adjusted returns that small-company stocks have historically realized over large-company stocks.
The second is Eugene Fama and Kenneth French’s seminal 1993 Journal of Financial Economics paper, “Common Risk Factors in the Returns on Stocks and Bonds.” This paper identified the market’s volatility, a company’s size (meaning market capitalization, the number of outstanding shares times the share price) and a company’s valuation (based on price relative to book value) as the key factors explaining stock market returns. Among its findings were the tendency for undervalued, small-cap stocks to outperform.
Since its inception in 1993, the Model Shadow Stock Portfolio has taken advantage of these studies by targeting small, undervalued stocks.
Clear Addition and Deletion Rules
Another trait all AAII model portfolios share is following clear addition and deletion rules. This is critical because process matters in investing, always.
Consider the Model Shadow Stock Portfolio. Its key addition rules are:
- Avoiding over-the-counter (OTC) stocks;
- A price-to-book-value (P/B) ratio ranking in the lowest 10% of stocks listed on the New York Stock Exchange (NYSE), currently 0.90;
- A market cap ranking in the lowest 10% of NYSE-listed stocks, currently between $30 million and $300 million;
- Positive earnings from continuing operations for the most recent quarter and the last 12 months; and
- Avoiding financial stocks and limited partnerships because of their different financial structures.
The model portfolio’s key deletion rules are:
- Negative earnings from continuing operations for the last 12 months (given a one-quarter probationary period for the company to return to profitability);
- The price-to-book ratio rises above three times the buy rule, currently 2.70; or
- The market cap goes above three times the initial criterion, currently $900 million.
A big part of the Model Shadow Stock Portfolio’s success has been its clear addition and deletion rules. The strategy’s rules have been routinely followed since the portfolio’s inception. As a result, unemotional and disciplined addition and deletion decisions have been made in the same manner, over and over.
Quantitatively Driven Approaches
New additions for all AAII model portfolios are selected from stock screens. These screens identify potential candidates with quantitative characteristics matching a strategy’s addition rules.
For example, the latest addition to the Model Shadow Stock Portfolio was selected from the Shadow Stock Ideas list. The screen populating this list seeks out exchange-listed stocks matching the Shadow Stock strategy’s main addition rules. Specifically, stocks trading with a price-to-book ratio of 0.90 or lower, a market cap no higher than $300 million and positive earnings from operations (Figure 2).
Stock screens—and similar quantitative approaches—identify stocks with specific criteria. These criteria can be valuation-based—e.g., price-earnings (P/E) ratio no higher than, say, 20—growth-based (e.g., earnings growth of at least 10%) and/or use other fundamental- or price-based criteria. Screens frequently identify stocks with attractive characteristics we or other investors may have overlooked.
AAII members who prefer to build their own portfolios instead of following one of the AAII model portfolios can use the AAII Stock Screens to find potential candidates. These screens identify stocks that appeal to growth, value, dividend and momentum investors. Some seek out small-company stocks, some large and some are agnostic when it comes to company size. Most importantly, they help you narrow down the universe of 5,500 exchange-traded stocks to those with the quantitative traits you are most interested in.
If Following an Active Approach, Don’t Invest Like an Index
Passive (index) mutual funds and exchange-traded funds (ETFs) do a great job of tracking the major indexes. The Vanguard S&P 500 ETF 
(VOO), for instance, gives you exposure to the S&P 500 index for a cost of just 0.03% per year. It is impossible for any active approach to match the return of the S&P 500 for this low of an expense ratio.
Related
Bluntly put, if you want the return of a major index like the S&P 500, buy a low-cost index fund.
If you want to beat the S&P 500 or some other well-followed index, you need to invest differently than it. We believe individual investors are better positioned to do this than professional managers. This is because individual investors are not constrained by prospectuses, investment committees or clients. They can look beyond what’s talked about by the financial media and seek stocks matching each strategy’s criteria. This is what we do with all AAII model portfolios.
This isn’t to say you must avoid large-cap stocks. Rather, you shouldn’t feel any obligation to limit yourself to them. The S&P 500 holds 500 stocks. The S&P SmallCap 600 index holds 600 stocks. The number of stocks discussed in the financial news media is even smaller. In contrast, there are 5,500 exchange-traded stocks for you to choose among. Expanding the universe of the stocks you will consider owning greatly increases your odds of outperforming.
Having the Resolve and Ability to Stick With a Strategy
This is the one characteristic of a consistent, well-defined approach to stock investing that is solely dependent on you. If a strategy is evidence-based and has clear buy and sell rules, then all that is needed for long-term success is your resolve and ability (both financially and psychologically) to continuously follow it.
This is why I frequently describe the optimal investing strategy not as one that maximizes return, but rather as one that helps you stick to your long-term investing plan. A strategy with a lower expected long-term return that you are able to stick with no matter what the market does is better than one you can’t stick with. No matter how high the expected return of a strategy, it is only as good as your ability to follow it consistently.
The big reason is volatility. Volatility refers to how much the returns of stocks, or other assets, move up and down. No one minds upside volatility. It is the fast and steep drops of downside volatility that unnerve many investors.
Cloonan referred to volatility as a phantom risk. He viewed real risk as whether you will have the money you need when you need it. Nonetheless, downside volatility can feel very much like a real risk to many investors.
Part of this is due to a lack of understanding about what’s normal and what’s unusual. Since the end of World War II, the S&P 500 has experienced 24 corrections. A correction is defined as a drop in the market of between 10% and 20%. There have been 14 bear markets (drop of 20% or more). Downward moves are a normal part of the market cycle. Most aren’t severe; the S&P 500 has only fallen by more than 30% six times since 1945: 1968–1970, 1973–1974, 1987, 2000–2002, 2007–2009 and 2020.
It’s also helpful to understand what is usual and what is unusual when it comes to fundamentals. Currently, we continue to see small-cap stocks trading at historically low valuations relative to large-cap stocks. Since 1998, the average price-to-book ratio for small-cap stocks has been 66% of the average price-to-book ratio for large-cap stocks. Currently, the price-to-book ratio for small-cap stocks is just 50% of the price-to-book ratio for large-cap stocks.
This wide difference suggests that small-cap stocks should be poised to outperform in the future. It should also give investors in small-cap stocks a reason to stay patient as opposed to abandoning them.
Numbers can only go so far. Your mindset and your ability to control your emotions and biases play an important role. The human mind has not evolved to deal with the complexities the financial markets bring. What helps is knowing what prompts you to act and setting up procedures to prevent you from acting on impulse.
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BEHAVIORAL FINANCE
Using the Power of the Written Word to Improve Your Returns
We believe written addition and deletion rules are key to investing in a consistent, well-defined approach—as previously stated. We also believe it helps to have a stated purpose for why you are investing. AAII’s PRISM Wealth-Building Process is designed to align your investing decisions with your goals. It also helps you decide what portion of your savings should be invested more conservatively to cover shorter-term withdrawal needs and what can be allocated to stocks for future growth. By being clear about what you are investing for and how you intend to get there, you will be more disciplined.
Becoming a Better Investor
The good news is that none of this is rocket science. These steps do not require an advanced degree or complex software. Rather what they require are:
- An understanding of your advantages as an individual investor,
- A willingness to expand the universe of stocks you consider,
- An approach based on research and data (such as that provided in the AAII Journal),
- Written buy and sell rules that are easy to follow and
- A willingness to invest differently than the S&P 500 if you actively invest.
Most importantly, being a successful investor requires following Cloonan’s two rules for investing success: One, develop a consistent, well-defined approach to investing in stocks; and, two, stick to rule #1.
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