Beat the market is an expression often used by finance professionals, but what does it mean to beat the market? Every day, something incredible happens. Investors around the world trade millions of shares worth billions of dollars. Some work alone, others in groups, and at the same time, advanced computer algorithms are also working to beat the market.
All these competing forces make it difficult to beat the market. However, a few investors are routinely able to do just that. We believe that with the right motivation, temperament, and mindset it is entirely possible for retail investors to do so. In fact, we believe that beating the market is not an impossible task. As a retail investor, you have a great advantage - you only have one client to satisfy. Beating the market is challenging but achievable if that client is long-term oriented.
What does it mean to beat the market?
When investors talk about "beating the market," they mean getting returns that are higher than the broader market. In a sense, this not only leads to more money in your account, but it also earns you a badge of honor: it means you've picked individual stocks or funds that have outperformed the market.
One caveat to keep in mind is that you can lose money and still beat the market. For example, if you lost 20 percent of your portfolio in 2008, it wouldn't have been fun, but you still would have beaten the market by 18 percentage points.
What are some time-proven investment strategies to beat the market?
There are a few discernible strategies that can be carefully implemented in order to consistently beat the market. Here are the most relevant:
Adjusting risk
If you want to build wealth over the long term and beat the market, it is less relevant if the volatility is higher in the short term. What matters is your long-term returns. Unfortunately, many are victims of risk aversion, as perceived lost money hurts more than realized profit. Analyze your portfolio and develop a wealth management and portfolio-building strategy that fits your investor profile.
If you are under 40, chances are you are an aggressive investor looking to accumulate capital rather than preserve capital. For these individuals, it is important to consider part of the portfolio allocation to assets whose expected returns are higher.
Therefore, your allocation to riskier assets can be over 50%, since young people are more willing to take risks. This is not speculation, but the acceptance that taking risks early in your life will also be rewarded in the long term. Stocks should therefore be the main asset class in the portfolio. There are several strategies that can be implemented, and perhaps a risk diversification approach seems to be the most effective. Thus, investing in riskier stocks that ideally with a low correlation between each other can allow you to achieve higher returns and beat the market.
Value investing
According to the Fama and French Model, stocks with a low price-to-earnings ratio outperform the market in the long run. This is rationally explainable because a price-to-earnings ratio of 10 implies that every year 10% of your initial investment could be distributed. Even without growth, this is a higher return than 5% for a stock with a price-to-earnings ratio of 20.
Stocks differ in their price-to-earnings ratios because of different growth prospects and earnings volatility. However, stocks with high price-to-earnings ratios tend to underperform those with low ones because ambitious growth prospects often don't materialize.
There are also other similar studies in the field of undervalued stocks. James Montier has calculated over a 10 year period that the cheapest stocks outperform by 5%. While the most expensive stocks underperform by 13%, which would be a market neutral return of 18%. These studies have consistently shown that value investing tends to beat the market over time.
Apply value investing like Warren Buffett
Warren Buffet is certainly the most accredited value investor the market has ever seen. His success stems from buying fairly valued stocks with a moat and holding them for a long time.
Ideally, you should look for good businesses at low valuations, including low price-to-earnings ratios. Warren Buffett focuses not only on the low valuation but even more so on the quality of a company.
His focus is not only on the quantitative side of the business but also on the qualitative. Over the long term holding quality businesses will generate market-beating returns. This is done by focusing on the fundamental analysis of stocks. Value investors will often focus most of their research using fundamental analysis rather than technical analysis. There are several fundamental analysis books that can help investors to understand value investing and security analysis.
Small caps
The three-factor of the Fama and French model also contemplates small caps.
In the long term, small caps tend to perform better than large caps. This is easily explained by the risk associated with each type of stock. Risk and returns are correlated, and therefore small caps are riskier, but they can also generate higher returns. Small caps also have more growth opportunities when compared with a well-established large cap.
For example, a company with revenues of $100 million could double its revenues with a new product or service. On the other hand, a company with $10 billion in revenues will have a harder time doubling its revenues.
Another preponderant fact is that small caps can retain higher valuations. As their growth estimates are achieved, there is still room for further growth. Another great advantage of small caps is that they are often overlooked by analysts. Analysts will often follow the large caps and even some medium caps, but due to the huge number of small caps, they are often overlooked. Finance professionals will often advise customers, and manage capital for their customers. They are less willing to invest in a small company, whose future is uncertain and therefore it is riskier.
Small caps can beat the market
This leads us to a conclusion that retail investors focusing on small caps have a great advantage. Since finance professionals and the broader market are focused on other companies they can research small caps, and find needles in the haystack. Institutional investors are often limited by the large size of their portfolios. They will look for investment opportunities in large companies, where they can deploy $10 or $100 million. This makes small caps look unappealing. Therefore they cannot invest in small caps, since the effect would be too small for their portfolio and their entry would also distort the prices.
Another reason for private investors to bet on small caps is that they are not included in the major stock indices and are therefore less exposed to macroeconomic factors. Large caps often have a higher correlation with the broader market. They will be more exposed to broad market risks.
Momentum effect
The momentum effect implies that the probability is higher than 50% that a rising stock will continue to rise and a falling stock will continue to fall. The well-known stock market saying "The trend is your friend" also sums up the Momentum Effect.
Although the momentum effect is still somewhat controversial in the academic world (i.e. whether it can lead to outperformance after transaction costs). Carhart was able to prove with his four-factor model that stocks follow a trend. Even very well-known hedge fund managers and investors know that this effect can work over the long term. By selecting stocks based on their trend movements.
An example of this is if a listed company publishes very good figures above expectations. This is often not directly priced into the share price. But only gradually understood by investors that become aware of the good results, which drives the price up.
There are also fads on the stock market that gradually become widespread, which then leads to even higher valuations. Last but not least, there are trend followers who analyze charts and jump on trends, making this effect a self-fulfilling feedback loop.
Since many institutional investors do not look at trends, this becomes an attractive strategy that retail investors can implement to beat the market. However, you should consider that trends and momentum are also responsible for larger upside and downside movements in the markets.
Implementing trend analysis in your investment strategy
Trend analysis can be implemented within each investment strategy. It allows you to spot early winners and possible long-term compounders. It makes sense to also look at the trends to time an entry and exit strategy for every investment or trade.
However, it is important that you do not look at trend analysis in isolation, but in the context of fundamental analysis. To take advantage of the momentum effect, higher trading activity is required and it is not suitable for buy and hold investment strategies.
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