It’s only a matter of time before an investor ask himself “can I do better than the market?”
We all invest pursuing the end result of growing our money and surely it is a relevant question to ask and making some extra money being smarter than average surely sounds good, but is it really worth pursuing?
What does “beating the market” mean?
First and foremost: what market are we talking about?
Although the term “market” is used loosely to refer to financial markets, we need to be more precise and those are not details.
One must define whether he is considering the international stock market, the U.S. stock market, the bond market or any other single market that makes up what we generally refer to as financial market. What market are you trying to beat?
Once the market is identified, we need to select an index that represents that market in order to consider the index as our benchmark.
For example, “the market’s performance” in the U.S. tends to be the performance of the S&P 500.
If the return of your portfolio (after commissions) is higher than the return of the benchmark over a specific time period, let’s say 1 year, you’ve achieved a greater return thus beating the market.
Achieving a return higher than the benchmark is the extremely simple definition of beating the market but it’s only a piece of the puzzle because return isn’t the only thing to consider.
There are three factors involved: time, risk and return.
The idea of beating the market and achieve a higher return compared to the benchmark holds true only if the risk of your portfolio is to some extent consistent with the index you selected.
This extreme example clarifies: if you beat the S&P 500 because you invested in just two high-tech small cap stocks you technically beat the market, but the risk profile of your portfolio has nothing to do with the S&P 500.
So, an investor, fund or portfolio manager beats the market if over a certain period of time his or her investment strategy produces a return that is higher than the benchmark, provided that the risk profile remains similar.
Is that even possible?
Can you beat the market?
Let’s be clear on one point: you can’t beat the market if you think and act like the market.
That is, don’t expect to beat the market by blindly invest into an index fund ad forgetting about that. It requires something more than buying the index.
Having said that, evidence suggests that beating the market is not an easy task at all.
In the following chart I reported the data from the SPIVA report (“S&P Indices Versus Active”) created by S&P Dow Jones Indices LLC about how many active funds overperformed the S&P 500.
The last 5 years of data clearly show that during one of the strongest bull markets of recent history more than 80% of actively managed funds didn’t managed to “beat the market”.
Another notable fact that adds up to the fact that most managers struggle to beat benchmarks over long time periods, is that winners don’t tend to repeat.
This makes even harder for a regular investor to choose one or more funds that are likely to overperform the market and should lead us to ask ourselves some questions about the fund management industry.
If the majority of finance professionals, very smart people, at the end of the day doesn’t manage to beat the index that most consider “the U.S. stock market”, how can you expect to beat the market?
Can you really beat the long-term average of 7% — 10% per year return of the S&P 500 by investing on your own?
It is not a chance that general wisdom says that the average investor is better off buying low-cost index funds, even Warren Buffett says that. That is simply because most investors won’t beat the market.
To be honest, I believe that beating the market over time is possible, although challenging, and has to do with you more than the market but most importantly it doesn’t mean that should be your primary goal.
How to beat the market
I think that what makes it possible to beat the market is your investing mindset and your investment strategy.
Short-term market movements are unpredictable therefore I am not suggesting to deploy the ultimate trading strategy aimed to time the market.
Economies change, companies rise and fall, technology evolution is bringing immense changes and other unexpected events can have huge impacts, like what is currently happening with the Covid-19.
Market prices reflect the average of dominant expectations about future returns and change every seconds as new information flow in. Trying to outguess the market is a losing game because you can’t do that consistently and repeatedly.
If you believe that picking individual stocks looking for undervalued opportunities is too risky, and that could easily be the case for any investor that doesn’t have time to dedicate to the research process, you can still carry out the strategy with low-cost index funds.
The way to beat the market is a long-term game that requires knowledge and discipline, setting reasonable expectations and not looking for immediate results.
Over the years, the results of your overall portfolio can be enormously different from “the market” and that should be the number one thing to care about.
For long-term investors, beating the market is a matter of being contrarian and being right about your contrarian view.
This requires thinking differently from the market.
What I mean by that is that often times the market is extremely short-sighted and highly volatile, but that doesn’t mean that you must have the same view.
That’s why you shouldn’t care that much about day by day market movements.
The market is not even rational or irrational, it just is. Therefore, you can focus on your strategy and goals and even take advantage of short-term movements.
If you have a long-term time horizon for your investments, looking for value during times of negative market sentiment, framing the events with the appropriate long-term view can give you an “unfair” advantage over your reference index.
Between the end of February 2020 and March 2020 the S&P 500 crashed more than 30%, many investors panicked and rushed to sell.
If you are a long-term investor that wants to beat the market and achieve higher returns for the years to come, I honestly hope you took advantage of the situation.
The point is not getting in or getting out to avoid the crash and benefit from the rebound, it is about framing the events differently from the market.
Do you believe that in the next 10–20 years we will be better off than now? If so, there are really few reasons not to buy. Focusing on the long-term allows to go beyond short term volatility.
Why most investors fail in the stock market
The performance of the average investor compared to “the market” defined as the S&P 500 is really a sad truth.
While everyone for any reason could miss an exceptional good day in the market, here I am talking about the long-term annualized return, what really counts if your goal is to retire or create wealth.
Data from the J.P. Morgan guide to markets reveal that the average investor’s performance is roughly 1/3 of the S&P 500, over 20 years!
That means that compared to the situation in which you buy the index and do nothing, at the and of the day investors behavior is responsible of this poor performance.
By definition, if you invest in any financial market you are exposing yourself to some degree of uncertainty. The key is to what extent one is able to deal with that uncertainty on the emotional level.
While many people who lose money blame the markets, the number one reason why investors fail is the lack of emotional self-control.
It’s rare to see regular people maintain an objective, rational and stable position regardless of what’s happening in the market.
Many people allow the market to dictate their emotions (greed, fear, impatience, panic…), stopping them from doing the right things.
The reason why the average investor performance over 20 years is 1/3 of the S&P 500 is because people find themselves onto an emotional rollercoaster that leads them to make investing decision that are the opposite of rational and seriously take down one’s investment strategy.
In one chart:
That’s why the average investor is actually very unlikely to beat the market.
It’s not only the emotional part.
Other factor come into play in creating a poor or outstanding performance. Factors like overconfidence, short-term focus, a higher sensitivity to losses than gains, poor knowledge and no sound investment strategy.
Overperformance or under performance: it all depends on you.
One thing that is often overlooked is that an individual investor actually has some advantages over professionals that can be surprising.
First, you don’t need to maximize short-term returns show any track record in order to keep the clients of your fund and avoid losing your job.
Many fund managers are forced to keep good short-term performances at the expense of long-term result. An individual investor with a solid emotional character has the privilege of being ok with some periods of underperformance.
Second, you don’t have any management fee to run your own portfolio and you just eliminated a big slice of what causes underperformance in managed funds. Keep an eye on commission and taxes.
Third, you have a small size and you can basically do whatever you want on the market without moving the prices of the market. When institutional investors buy and sell positions in their billion dollars portfolios, they cause prices to move up or down because the demand outweigh the supply and vice versa.
In addition, you don’t have any strict mandate on what you can invest or can not invest in, you can invest in whatever market segment you want.
Is beating the market really that important?
While beating the market and having more money in your account sounds appealing, is it really worth pursuing?
Of course you want to achieve fair returns but your goals have nothing to do with beating the market. What you really want is a plan that helps you reach your goals.
And if you feel that buying index funds is not sexy, just remember that market returns are actually significantly above average when compared both to fund managers and average investors.
Beating the market should not be your number one goal because it takes you off from the real goal, that is why you are investing.
In conclusion, while beating the market is actually possible, it is a matter of time, energy effort and knowledge that in most cases will only lead to poorer performance. For many investors, this is just irrelevant to the final goal and forgetting the desire to beat the market at the end of the day will lead to higher performances.
Those who beat the market are people that dedicate their life to investing and probably love what they are doing. If you are one of those, I honestly hope that you’ll succeed with your knowledge, preparation and strategy.
If you think that there are better ways to spend your time it’s great, you can achieve incredible financial goals provided that you don’t pretend to be the #1 investor on planet earth and don’t mess things up permanently.
In both cases, realize that the path to be a successful long-term investor is a well beaten one and anyone can really become one.
Originally published at https://moderntimesinvestors.com on June 13, 2020.
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