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Introduction

In investing, to beat the market is a kind of holy grail. In this writeup, we will first see what we mean with "beating the market". Then, the two most common strategies for beating the market are discussed. I will use stocks as an example, although the principle applies to other markets as well. Then, we will see how we can blend these strategies.

This writeup is meant as an informative piece. It is certainly not meant as investment advice.

What is this market we are trying to beat?

This is a very good question, with no real answer. If we restrict ourselves to stocks, one could argue that if we outperform the index, we have done well. If we restrict ourselves to investing in domestic stocks, it makes sense to pick a domestic index, such as the Xetra DAX for investments in Germany, the S&P 500 in the USA (the Dow Jones is not a very good benchmark, as it has a very archaic weighting). If we restrict ourselves to the Eurozone, the Eurostoxx 50 is a likely candidate. If we invest all over the world, the MSCI World index could be a good choice.

The choice of a proper yardstick is quite important here. The risk and potential reward for investing in third-world countries, rather than in first-world countries, is quite difference and cannot be compared. It is even possible to use different yardsticks for different parts of a portfolio. This is especially handy if one invests part in bonds, part in stocks and part in other asset categories.

However, beating the index is not enough. You see, stocks pay a dividend. This is typically between 2 and 4% of the value of stocks per year. An index generally does not consider this. So, if I were to buy the S&P 500 Index for 1000, and the S&P 500 Index were to go up to 1050 in one year I would actually have made more; the dividend, so our actual profit would be closer to 80 than to 50, assuming 3% dividend. Many funds do not consider this. So, if a fund beats the S&P 500 in our example by 1%, making 1060, the fund still returns less than the S&P 500. In my personal opinion, this is one of the most brilliant scams that banks pull over their customers. The exception here are so-called total return indices, which reinvest the dividend in stocks and as such incorporate it in their value. The most well-known example is the Xetra Dax.

Stock picking

One of the methods to beat the market is stock picking. In this strategy, a stock that is perceived to be undervalued is bought. The idea is that this stock rises faster than the rest of the market, hence beating it. This is the way Warren Buffett became rich. There are two hard parts here:
  • Making sure your stock is actually undervalued, and not just some horrible piece of junk
  • Making sure the stock is actually outperforming the market, and not just more volatile. This deserves some explanation. It is relatively easy to find stocks that do better than the market if the market is going up, but less so if the market is going down. banks and insurance companies are a good example of this, but tech stocks are also well-known. The goal is to find a stock that outperforms the market over the long term, through bull and bear markets.
Stock picking is probably the most popular way of trying to outperform the market. It is aimed at long-term potential, as in the short term, the market price and the "true value" of a stock, whatever that may be, could diverge.

Timing

10 years ago, the S&P 500 was at around 1400. Now, it it is at around 1100. Even including dividends, over these last 10 year it is doubtful it has done better than the risk-free rate. However, if we would have bought the S&P 500 a 1400, kept it for about a year, sold, bought back in the middle of 2002, and sold again in Nov 2007, only to buy back in March 2009, our return would have been about 230%, or 13% per year, excluding dividends.

This illustrates the power of timing. By buying shares at a low in the market, and selling them at a high, we can beat the market. This can be done at many timescales; a few times per decade, as above, weekly, daily or even intra-day. Timing is in general very hard, just like stockpicking; it often involves cutting losses, which is psychologically difficult to do.

Combining them

The two strategies outlined above can be combined in an infinite variety of ways. For instance, it is possible to buy risky stocks if one is confident the market goes up, and switch to less risky stocks if the market goes down. It is also possible to buck stock that is perceived to be undervalued, but not considered a great long-term investment. derivatives can also play a role; it is possible, for instance, to sell a call if one thinks the market is not going to go up for a while, and/or to buy a put if one thinks it will go down. Another way of doing this is by for instance allocating half a portfolio to stocks that are thought to outperform the market in the long run, and using the other half to buy trackers, which are sold when one thinks the market is going down.

It is important to emphasize that active trading strategies are more costly. As such, it is important that the money gained from the active trading is sufficient to recoup these costs.

Conclusion

In this writeup, we have discussed two basic strategies to beat the market. One revolves around picking assets that are expected to outperform the market. The second revolves around being in the market when it is rising, and out of it when it is not. These two strategies can be combined in many different ways.

Disclaimer: this writeup is not meant as investment advice, but more as general background material. Do not take investment advice from anonymous strangers.

One anonymous stranger's thoughts follow. These ideas have worked for me.

if you are lucky, you might try to beat the market by throwing darts at the quote pages. There must be a better way for the rest of us. Let's explore that.

Do not suppose you can beat the market, until you do.

If you do, then, next time, be equally, or more, careful.

Beating the market is choosing to put your money in things that do better.

Some people rely on a fund manager or broker to make decisions for them. That may be best if you don't want to make decisions. On the other hand, when fund managers are losing money, or getting bail-outs, you may prefer to make your own decisions. You might consider buying and selling individual stocks and funds, and manage that yourself.

Be aware that day trading, and short-term trading, require meticulous knowledge and continuous attention, which most people don't, and won't, have. This write up does not treat day trading or short term trading.

Instead, you might try buying good stocks and funds, at the right time, intending to hold them and make profit (they're good?), and check out how they're doing, as time permits.

If you want to buy stocks, pick good stocks.

How might someone pick and buy good stocks? Here are my thoughts.

First, where do you want to invest? Some countries are doing better than others. Find them.

Second, what companies in those countries are worth a look?

Third, pay attention to your gut, instinct, or intuition-- ask yourself, does this make sense?

Picking the right markets, the strong emerging markets that are growing, is pretty easy to do. You might look at Globaledge, Market Potential Index for Emerging Markets for a take on that.

Find stocks, in those places, that are traded on your local stock exchanges, something your broker can do. For example, India's TATA Motors trades on NYSE as TTM, Poland's big drink distributor trades as CEDC.

Having found a region that's growing, and some stocks that you can easily trade, it's important to examine, and rate, the P/E, ROI, ROIC (Return On Invested Capital), and cash flow, over time. If these ideas are new, take a look at Financial Ratios. Compare any company to other companies in the same industry. Rate and rank. Be aware that some numbers will be fudge, even with listed companies. Do the research.

Some basic stats and charts are available free at Yahoo finance.

Find good companies that have good (low) P/E, good (high) ROI and ROIC, positive cash flow, and growth over time. Compare them to their competition.

Ask yourself, is this something you think you know about, or have any intuition about?

Time your buy(s). Pay attention to overall market trends, don't fight them. A great stock can, and probably will, rise or fall with the trend. In a general market downtrend, cash or bonds/funds can do better. There are funds that deal in specific countries' government bonds (if you want something managed, consider MERKX for a portion of "near cash" holdings). If you plan to buy more than a few hundred shares of anything you might spread the buying a little, and buy on the dips.

Don't put all your eggs in one basket, and be willing to have some patience. Re-examine your decisions and ask yourself which ones still hold water.

There is an emotional content to buying and selling, taking profits or losses. One guy told me taking a huge trade profit was adrenaline better than sex. Keep your head. Be willing to take losses, and profits. If you are feeling really pumped because your investment did really, really well, that may be a sign it's time to sell some or all of that. If you feel lousy because something went down, do your re-analysis and soul searching. If you think it's less likely to go up than when you bought it, then sell.

Your mileage may vary, as you make your own decisions.

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