Something to think about… if you really can’t buy index funds – Part 2

Plenty of people refuse to buy index funds.

They feel that they can invest with individual stocks, and beat 90 percent of investment professionals—on their own. With a portfolio of indexes, you would beat 90 percent of the pros over your lifetime, so based on deductive reasoning, if you think you can beat an indexed portfolio after fees and taxes, then you’re making a wager that you can beat 90 percent of the folks who pick stocks for a living.

I’m not going to rain on that parade, if that’s what you think. In fact, I may be able to help you out.

Beating the Dow with Bonds gets my vote as one of the classic investment books of all time. Whether you buy into author Michael O’Higgins’ strategy or not, it’s tough not to come away impressed by his clear sense of how the stock and bond markets work. And over a lengthy period of time, it’s tough to argue with a strategy that has compounded very strong results…and would have easily beaten a diversified portfolio of index funds.

I’m not going to get into the details of his strategy—for that, I strongly recommend that you buy the book.  But I do want to examine the results of his “Beating the Dow with Bonds” method, which directs investors into either 30-year bonds, one year T-Bills, or the Dogs of the Dow.

I’ll be comparing the historical returns of the following:

1. The Dow Jones Industrial returns

Vs.

2. O’Higgins’ “Beating the Dow” strategy (a strategy explained in his 1991 book, Beating the Dow and popularized since then as “Dogs of the Dow”)

Vs.

3. O’Higgins’ “Beating the Dow with bonds” strategy (explained in his 1998 book, Beating the Dow with Bonds)

And I’ll compare the results annually, from 1972 to 2010, using O’Higgins’ book as a source (until 1998) coupled by an email communication with Mr. O’Higgins, to update the results to June 2011.

I’ve highlighted the years where O’Higgins’ “Beating the Dow with bonds” strategy would have beaten the returns of the Dow Jones Industrials.

Since 1972, the strategy outlined in Beating the Dow with Bonds beat the Dow Jones Industrial returns 65 percent of the time.

But it’s the cumulative, comparative returns that look most impressive, with O’Higgins’ strategy up +48,384.68 percent, versus 4,317.88 percent for the Dow.

Have a look at the comparative numbers again. No, there’s no typo there.

Why have these returns beaten the market so handily?

In my opinion, these returns have done so well because they’ve relied on a contrarian nature…coupled with common sense. Investors are generally ruled by fear and greed—and I’m including the talking heads and analysts on television and newspapers as part of the general herd. When stocks perform well, most people pile money into them. O’Higgins’ mechanical strategy dictates common sense over an emotional knee-jerk reaction, prompting investors to buy whatever asset class has recently under-performed: either the worst performers in the Dow at the time (the Dogs of the Dow) or long-term treasuries or T-Bills.

But since the publication of O’Higgins’ 1998 book, how did the strategy do?

O’Higgins’ strategy, since 1998, beat the market (as measure by the Dow) 57 percent of the time. But the year 2008 sank the strategy, putting it behind the market, since 1998, on a cumulative basis.

This begs the question. Will this strategy beat the markets going forward? Or are the long term results a statistical fluke? You tell me.

I do think that Michael O’Higgins is probably a genius, and that he’s definitely a man to follow if you want to try beating the market on your own. In fact, I couldn’t recommend a better guide.

In part 3 of this series, I’ll explain O’Higgins’ latest strategy, which is also contrarian. And if its future results echo his past results, it might be worth tuning in.

Part 1 – Part 2 – Part 3