Beating the market is as challenging as it sounds, and not every investor is able to do it. Well since not even fund managers with years of experience in the market can beat the indexes, how can you do it? And how can you even beat the market by replicating index funds?
In this article, we will reveal how index fund investors can beat the market with 3 simple steps.
No, it is not easy to beat the market at least in the long run. However, it can be easy to beat the market in a given year or for 2 or 3 years, but to beat the market consistently over the course of more than 10 years, only a few professional investors are really able to do it.
What are the odds of beating the market?
According to Performance IG, the odds of beating the market in a given year are 25%. That percentage decreases to 6.25% when you try to beat the market 2 years in a row.
When you start considering the likelihood of beating the market every year over a 10-year span, the probability of that happening is close to 0, and it stands at 0.00000095%.
Why most investors underperform the market
Since an investor only has a probability of beating the market in one year of 25%, that means that ¾ of investors actually underperform the broader market. This is one of the reasons so many investors, and fund managers actually recommend investing in index funds because it will be a better long-term investment.
But what if there was a way of investing in index funds, and still slightly beating the market?
How can you beat the market?
For full disclosure, this approach only works if your portfolio is sizeable, and it will only allow you to slightly beat the market because it involves a passive portfolio management approach.
However, to beat the market by a lot on a relative basis you need to be able to be an excellent stock picker and have an outstanding active portfolio management strategy.
3 Easy steps to easily beat the market
Step 1: Choose the index you want to outperform
The first step is choosing the index you want to beat, the idea is that your portfolio should be a copy of the Index to mimic its performance.
This will make sure you have the same returns as the index as long as your total portfolio value is big enough. So that the commissions are a residual portion of the total portfolio and won't lower your returns.
Step 2: Getting a broker who gives you interest on short borrow
The next step is to make sure you find a broker that offers you interest to lend your shares to other investors that want to short them. This is where the outperformance comes in, when a broker lends shares to an investor to short they will charge interest on the amount borrowed.
Some brokers reward their clients by giving them a percentage of the interest they charge so that they lend their shares to short sellers. This is called fully paid lending, by most brokers while others might use different names.
By using brokers that pay you interest on your shares that are lent to short sellers you will be able to have the same return and an added interest received for lending shares to short.
What brokers allow you to receive interest on the shares you lend?
There are several brokers that offer this to their clients, including Interactive Brokers, Fidelity, TD Ameritrade, and even E*Trade.
Step 3: Building the Portfolio
All you need to do now is to buy the same securities that are in the index you want to beat. Keep in mind that you will have to make the necessary adjustments when the index adjusts the weight of each stock, and different stocks are added or removed.
It is important to know that your portfolio needs to have a certain size so that the commissions charged will not materially affect the returns.
While some retail investors might be able to beat the market in one year, or two or three, the likelihood of being successful over a span of over 5 years, is extremely low. This does not mean that it can’t happen, and in fact, some investors are able to do it.
However, the number of investors that can actually do it is extremely small. Additionally, you might even wonder if there is actually skill involved in their stock picking or is it just luck.
Most index funds have a management fee that is deducted from your investment, although there are index funds that have no cost associated.
Even with the latter, building a portfolio that mimics the index you want to beat and lending your shares will generate a higher return and allow you to slightly outperform.
Despite being extremely difficult to beat the market, the steps provided here will allow a passive investor to improve its returns. If you are invested in index funds, consider this as a way to boost your returns.
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