staying ahead of a rising market is difficult

That’s the cliché, anyway.  And, for what it may be worth, my experience is it’s true.  It’s much harder to stay ahead of a rising market than a falling one.

but why?

Let’s first get a technical, or maybe a definitional, point out of the way.

The world consists of growth investors and value investors–both, by the way, claiming to be in the minority (because that’s cooler than being run-of-the-mill).  Value investors stress defense.  They’re more risk averse.  As a result, they typically make their outperformance during the part of a market cycle when stocks are going down.  Of course, they’d like to outperform an uptrending market.  But because they put defense first, deep down they know they should be satisfied (even ecstatic) to keep pace in a rising market.  Their approach to the stock market, their longer term strategy, is to protect against possible downside.  So they know that not falling too far behind is the best they can realistically hope for. Let’s not count them.

So our question really is:  why is so hard for growth investors, whose strategy calls for them to make their outperformance in an up market, to do so?

I think a lot is due to the fact that a rising market attracts substantial amounts of new money to stocks.  Not only that, but the new money doesn’t come in all at once; it arrives at different times.  depending on timing, new money can create demand for many stocks, not necessarily those best positioned to benefit from the bull run.

For example:

– (Almost) every professional investor is taught from day one not to “chase” stocks that have already risen a lot before he starts to look at them.  Instead, he’s told, look for stocks that may not be quite as good but which haven’t moved yet.

Someone late to the smartphone party might not buy Apple or ARM Holdings.  He might buy Qualcomm instead.  Money arriving later still might gravitate toward a contract manufacturer like Hon Hai, or to Intel, or maybe even Verizon or Sprint, on the idea that smartphones or tablets will add oomph to those businesses.

These latter stocks may not necessarily be the purest plays or the greatest companies, but buyers will tell themselves (sometimes rightly, other times wrongly) that the risk/reward tradeoff is better for them than for the more expensive “pure play” stock like AAPL or ARMH.

Put another way, when the leading lights of an industry make a major move upward, they tend to drag a lot of the lesser lights along with them–at least to some degree, from time to time and with a lag.  It’s very hard psychologically–and arguably not the best idea financially–for someone who has identified a trend early and holds all the major players to rotate away from them and dip down into second-line stocks to play these ripples.  But during a period while others are playing catch-up by bidding up the minor stocks, the holder of industry leaders will underperform.

–There’s also a more general arbitrage in an up market–in any market, really, but more so when stocks are moving up.  It’s not only among relative valuations of participants in an industry which is on Wall Street’s center stage, but between that industry and other sectors/ industries/stocks.

Let’s say that tech stocks have gone up 40% in the past six months, while healthcare names have lost 5% of their value.  At some point, even tech investors will start to say that healthcare stocks look relatively cheap.  As this perception spreads, the market will direct its new money flows to healthcare.  Investors may even begin to rebalance–selling some of their tech stocks, and using the funds to buy healthcare, until a better relationship in valuation is restored.  While this is going on, anyone overweight tech and underweight healthcare will probably underperform.

should you want to outperform all the time?

If there were no tradeoffs, the answer would be easy.  But there are.

–All of us have different goals and objectives.  Younger investors, for instance, will probably want maximum growth of capital.  Older investors may want preservation of income, instead.  The former objective is consistent with trying to shoot the lights out in a bull market.  For the latter, that strategy is too risky.

-Not everyone has the temperament to be good at investing.  That’s just the way it is.  Someone who falls below the market return year in and year out should realize that for him active management is an expensive hobby.  Index funds would be a better wealth-building alternative.

–We also have different knowledge bases, aptitudes and interests.  That may make us better at defense than offense, or better at value investing than growth.  As in just about everything else, we should play to our strengths, not our weaknesses.

–Contrary to the wishes of the marketing departments of investment firms, no investor–not even the best professional–outperforms 100% of the time.  The other team eventually gets a turn at bat.  If you can outperform for two or three years out of five, and if your overall results match or exceed the market return for the half-decade, that’s more than enough.  That would put you deep in the top half of all professionals.

I don’t think this last is a crazy expectation for a non-professional.  Investing is a craft skill, like, say, baseball or shoe repair.  It can be learned.  Knowing a few things better than the market does will likely bring better than average long-term returns, even with occasional bouts of underperformance.