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.