Every investor dreams of beating the market. And if you want to beat the market, your portfolio must look different than the market. But first, what is “the market”? If you define it as the S&P 500 (which is comprised of large-cap stocks in the US), simply owning some small-cap or international stocks can make your portfolio different. And, as luck would have it, either strategy would have easily surpassed the S&P 500 over the last six months.
But looking different only gives you a chance to beat the market, it’s hardly a guarantee. In the six months prior (December 2019 – May 2020), looking different would have cost you.
A similar case could be made for nearly any investment. Take Tesla, for example. As perhaps the most polarizing stock ever, it’s a popular choice for those seeking to outperform the market (either by betting on its rise or its fall). In the first half of 2019, the company was crushed by 51%.
Tesla investors may not have been knocked out, but they were definitely knocked silly. Those that managed to hang on have been rewarded in 2020, with a casual 653% outperformance (not a typo).
Any investment strategy that differs from “the market” will have periods of over-and-under performance. That includes any individual stock, mutual fund, ETF, cryptocurrency, or commodity. Clearly, timing is everything, and perfect timing requires a lot of luck. Nobody wants to rely on luck, though, so here is the luck-free definitive guide to beating the market:
1. Predict major market-moving events. An accurate prediction of, say, US GDP, might be useful.
2. Gauge whether the market’s current price is overly optimistic or pessimistic, relative to your prediction. When GDP fell by the largest margin since the Great Depression in Q2, the S&P 500 responded with a shoulder shrug, falling by only 0.36% on the day of the announcement. In the month following, the market surged nearly 8%. An accurate GDP prediction would help, but only to the extent that your prediction is better than the market’s consensus.
3. Place bets accordingly. If the market is overly pessimistic, buy, if it seems overly optimistic, sell. The more conviction you have, the larger your bet should be.
4. Determine when a trade has run its course. If you are right and have made money, another decision awaits: close out the trade and take your profits or maintain your bet in hopes of earning more. If you’re wrong and losing money, you are faced with an even tougher decision: admit defeat and cut bait to limit your losses or keep holding on because the market hasn’t agreed with your “correct” opinion yet. This step is crucial – a mistake here can quickly turn a market-beating trade into a disaster.
5. Immediately adapt to unforeseen circumstances. A highly sophisticated model for predicting GDP would require inputs for all kinds of variables including inflation, employment, consumer spending, and interest rates. With accurate assumptions for those variables, the model would probably be extremely accurate most of the time. But nobody on Earth factored “once-in-a-century pandemic that will turn the world upside down” in their models for 2020 GDP and yet this unforeseen variable is all that has mattered. When new information arises, you must be able to abandon all previous beliefs in an instant.
If those five steps seem nearly impossible, it’s because they are. That’s why the vast majority of those seeking to outperform the market fail. Daniel Kahneman, Nobel Laureate (Economics) takes it a step further, saying, “This is one of the great mysteries of finance: Why do people believe they can do the impossible? And why do other people believe them?”
Kahneman was probably asking rhetorically, but I have a few theories:
- The potential reward is so great. Nothing has generated and protected wealth over the long-term quite like a diversified stock portfolio. But “buy a low-cost index fund and wait a few decades” is awfully boring advice, requiring patience that most people simply don’t have. The temptation to make a quick buck is irresistible, always has been and always will be.
- FOMO. Maybe I’m in a bubble, but along with weather and sports, the stock market is something that almost everyone likes to talk about – especially when it’s going crazy. That’s why so many people will sit through a commercial break to hear a hot stock tip on CNBC or read a YahooFinance article titled “Why This Stock Could Quadruple by Year-End.” Fear of missing out is a strong impulse because we compare ourselves to our neighbors, not our ancestors.
- Hindsight bias. “Of course Tesla is +670% this year. It’s the most innovative car company led by the most visionary CEO. They are the future of automotive transportation, high-performance batteries, and within the next decade we’ll all be zipping around Mars in self-driving Teslas.” Our brains are hardwired to think, “I saw this coming before it happened.” This mental quirk is great for our egos but terrible for our portfolios. The best way to combat hindsight bias is to write down a few of your bold predictions and wait a year before grading them. It might be a surprisingly humbling experience.
- It’s fun! My interest in investing began when I was around 12 years old and I started a “paper portfolio” picking stocks with my grandpa. Throughout college, I learned more about researching stocks and how to analyze financial statements. Over the years I did just okay, with some big winners and some big losers, but it was great entertainment. If not for compliance hurdles associated with my current job at Truepoint, I’d probably have a Robinhood account and still be stock picking as a hobby. I never want to discourage anyone from giving it a try – it’s a great way to learn and a ton of fun. The thing is, betting on sports is (allegedly) fun too, but nobody should ever jeopardize their retirement doing it. If you do want to “play the stock market,” only do so with a tiny slice of your net worth, an amount of money that you are willing to completely lose. If you do end up with some big winners, enjoy it, but try to ask yourself whether it was luck or skill. Unless you successfully completed the five-step guide, fortune was likely in your favor.
Disclaimer: Truepoint Wealth Counsel is a fee-only Registered Investment Adviser (RIA). Registration as an adviser does not connote a specific level of skill or training. More detail, including forms ADV Part 2A & Form CRS filed with the SEC, can be found at TruepointWealth.com. Neither the information, nor any opinion expressed, is to be construed as personalized investment, tax or legal advice.