Beating the Market: The Hare and the Tortoise

The Tortoise and the Hare is one of our favorite fables, telling the story of a race between unequal partners. Investors often describe their goal of beating the market. But much like in the fable, the race is not always to the swift. Instead, investing is a long-term game.

From a 10,000ft perspective, the stock market has historically provided high returns. The chart and table below show the historical performance of the S&P 500 after 1990 over various rolling periods.

S&P 500 since 1990

Investment periodMinimum CAGRMaximum CAGR
12-month period-49.49%+72.28%
60-month period (5 years)-8.35%+28.55%
120-month period (10 years)-4.14%+19.89%
240-month period (20 years)+5.56%+9.99%

For those patient enough to invest over 20 years, historical returns have been somewhere between 5.5% and 10% per year. If we can sustain gains somewhere towards the top mark of this range, we should be doing quite well.

Unfortunately, we often don’t have 20 years. Over ten years, it is quite possible to yield negative returns. An example of such a lost decade included the burst of the dot-com bubble in 2000, followed by the housing crisis in 2008. Investors should anticipate seeing similarly unpleasant periods in the future. If we shorten our investment further to 5 years, or even shorter, the picture becomes increasingly worse.

This variability is the reason for asset allocation: We need to reduce risk and make results more predictable. Mathematically speaking, we aim to reduce the standard deviation of returns.

Protecting the Downside with Strategic Asset Allocation

The typical answer to this is strategic asset allocation, which diversifies across asset classes. In its purest form, investors combine stocks with bonds. Let’s have a look at the same chart and table for the ubiquitous 60/40 portfolio:

60/40 portfolio since 1990

Investment periodMinimum CAGRMaximum CAGR
12-month period-29.14%+39.88%
60-month period (5 years)-2.67%+19.85%
120-month period (10 years)-0.07%+15.24%
240-month period (20 years)+5.02%+8.61%

What has changed? Most importantly, our time horizon has shortened: With the 60/40 portfolio, we can be pretty sure to at least break even over a period of 10 years. Our minimum growth rate has improved more than our maximum growth rate has suffered. In other words, our return per unit of risk, the so-called risk-adjusted return has improved.

Now, did we beat the market? That depends on the period we are looking at, but most likely not. However, quite possibly, that’s not the point. We invest for a purpose. For most investors, that’s to save for retirement. And when planning for retirement, it is more important to focus more on what we can safely rely on, than hoping to achieve a best-case scenario. This thinking is similar to buying an insurance policy: we don’t expect to make money with it. Instead, we aim to prepare for bad times.

This simple 60/40 portfolio has done a remarkable job of making the stock market returns more predictable and easier to stomach. We can use this result as a baseline, improve upon it, and benchmark our results against it.

Strategic asset allocation does not stop here. Instead of using a simple 2-fund portfolio, we can use more complex portfolios, including global stocks, real estate, commodities, gold, and inflation-protected bonds. With improved diversification, the returns become steadier, and risk-adjusted returns improve. However, a portfolio’s absolute returns typically decline, the further we reduce the allocation to stocks. Beating the market becomes more unlikely.

Introducing Tactical Asset Allocation

As a next step, we add a dynamic component: We progress from strategic asset allocation to tactical asset allocation. For this post, we use a crude trend-following method: invest in the S&P 500 when it’s trading above its 200-day moving average and switch to treasury bonds otherwise. This approach is not that different from our passive 60/40 before: Instead of combining the benefits of both asset classes by being invested in them simultaneously, we flip-flop between them. As before, we look at the equity curve and rolling returns:

trend-following since 1990

Investment periodMinimum CAGRMaximum CAGR
12-month period-16.62%+53.10%
60-month period (5 years)+2.15%+24.93%
120-month period (10 years)+3.91%+15.30%
240-month period (20 years)+5.95%+11.62%

These results mark another tremendous improvement. We can now be reasonably sure to break even within just five years of investing. Overall, the gap between minimum and maximum growth rates has narrowed, and across most timeframes, the results have improved. We have made further progress towards making returns more steady and predictable.

Did we beat the market this time? That’s a question of perspective. During bullish and uneventful periods, we are about on-par with the S&P 500. During recession periods, we are doing much better. But when quick rebounds follow sharp losses, we trail. Overall, this experiment trails the S&P 500 by only about 1% over the past 30 years. And we achieve this result with significantly less risk, and even though we trail the S&P 500 in most years. The secret to this result is to lose less during those two nasty recession periods.

There are many approaches to tactical asset allocation. For most of them, a large part of their edge over the market stems from doing better during economic downturns. To evaluate these portfolios, we need to analyze their performance over the full economic cycle, including at least one recession. In early 2020, our last recession was almost 12 years ago. Therefore, looking at five or even 10-year returns does not suffice to make informed decisions about most portfolios.

Beating the Market in the Long Term

When thinking about performance and beating the market, it is essential to do so in the context of risk. By merely applying leverage, we can scale up returns and risk in equal terms. Therefore, beating the market is not a useful goal unless we constrain the risk.

Our previous experiment has not increased our absolute returns, but we have substantially reduced our risk. The following experiment illustrates how we can use this to our advantage. We leverage our portfolio by an additional 20%, resulting in 120% exposure. Doing so leads to the following equity curve and rolling returns:

applying leverage to trend-following since 1990

Investment periodMinimum CAGRMaximum CAGR
12-month period-19.91%+66.22%
60-month period (5 years)+1.73%+30.10%
120-month period (10 years)+3.97%+18.09%
240-month period (20 years)+6.67%+13.43%

This result is interesting in multiple ways. By applying only modest leverage, we now lead the S&P 500 over the observed 30-year period. All of our minimum growth rates are better than the S&P 500, suggesting our portfolio still has a lower risk profile. At the same time, for timeframes of 5 years or more, our maximum growth rates are very similar to the stock market.

Did we finally beat the market? If we are in it for the long term, and if we have the patience to rely on doing better in the next recession, we most likely do so already. But if we are focused on comparing our strategy’s returns against the benchmark quarterly, we will probably still be disappointed.

Can we beat the market? Yes, we certainly can! Though applying more leverage, we can probably double our returns, before reaching the same maximum drawdowns as the S&P 500. However, we prefer sleeping better at night, knowing that we are protected against deep and prolonged losses.

The Race Is Not Always to the Swift

Our hypothetical portfolio is very simple and not a product we offer or would recommend. But it is a helpful thought experiment, leading us to the following conclusions:

  • Beating the market is not a useful goal. We need to always consider returns in the context of risk. If a portfolio offers higher returns in conjunction with higher risks, we should compare risk-adjusted returns.
  • Investing is a marathon. Quarterly or annual returns provide only very little insight into the long-term viability of an investment strategy. Instead, we should analyze performance over the full economic cycle.
  • Investing is psychologically challenging. Be prepared to trail the index for many years, to ultimately reap the benefits of an investment strategy. Resist the urge to jump on the next shiny thing.

We hope that this post provided some insight into the notion of beating the market, and why comparing the last ten annual returns is not a suitable method. At Bertram Solutions, we pride ourselves in doing independent research, and this post is an example of our approach to analyzing investments.