Beating the market is possible, but it is harder than it looks, takes years of study, and requires a great deal of due diligence. However, the payoff is worth it.
Studies show that the overwhelming majority of fund managers cannot beat an unmanaged benchmark like the S&P 500 or the Russell 2000. Approximately 3 out of 4 of them fail every year. Over longer periods of time, more than 95% of them do. (And research shows that ordinary investors are just as hapless.)
But an article in The Wall Street Journal 2 weeks ago argued that "the traditional indexes can be beaten—if you know how."
Indeed, they can. But it is harder than it looks, takes years of study, and requires a great deal of due diligence. However, the payoff is worth it…
The best-known strategy is "the value effect," buying companies that are inexpensive relative to their sales, earnings, book value, and dividends. This is the approach pioneered by Benjamin Graham and perfected by his student, Warren Buffett. It offers not only the potential for exceptional performance but a high margin of safety as well, since you are buying assets for less than their intrinsic value.
The other well-known way is to buy the opposite kind of stock: high-quality, expensive ones. A study published last year by Cliff Asness and Andrea Frazzini, of hedge fund AQR Capital Management, and Lasse Heje Pederson, a finance professor at New York University, found that companies with above-average rates of profitability and earnings growth tend to trounce the market averages, too. However, these kinds of stocks tend to be volatile. Nothing plunges like a growth stock after an earnings miss.
However, there are two other market-beating strategies worth mentioning.
The first is buying the same stocks the insiders are buying. After all, corporate officers and directors have access to all sorts of material, nonpublic information about the companies they run. That gives them an unfair advantage when they trade their own shares. So the SEC requires them to file a Form 4 detailing how many shares they bought on what date and at what price.
This doesn't just sound good in theory. Dozens of studies have shown that stocks under heavy accumulation by insiders outperform the market averages by a wide margin each year. It's not hard to see why. Insiders know the direction of sales since the last quarterly report, new products and services in development, whether the company has gained or lost any major customers, the status of pending legislation, and all sorts of other relevant data. Riding the coattails of knowledgeable insiders is one of the best ways to outperform the market averages.
However, one strategy that offers the highest probability of long-term success is actually the simplest. In fact, you don't have to know anything about macroeconomics, geopolitical affairs, business fundamentals, or Fed policy. All you have to understand is basic human psychology—and the tendency of history to repeat itself.
It works like this. If you see investors are scared out of their wits, morose about the future, and taking their broker's name in vain: buy. And if you hear them confident about their portfolios, optimistic about the future, and bragging about the size of their profits: sell. It's that simple.
The problem is it takes many years and sometimes a decade or more to get these clear-cut, table-pounding turning points. (And we aren't there right now.) But even when we are there, most investors are emotionally unable to pull the trigger. It just feels wrong to go against the herd. "And besides," they'll tell you, "I never expected to see this." (This, you understand, is something different each time: war, inflation, depression, terrorism, etc.)
If you can move against the crowd, you are that rare breed: a genuine contrarian—and your long-term success is virtually assured. If you can't, then stick to using value, growth, and insider buying.
But make sure to run your stops … because someday in the future investors will once again be scared out of their wits, pessimistic about the future, and taking their broker's name in vain.
And then you'll have another great buying opportunity.
The information contained in this article should not be construed as investment advice or as a solicitation to buy or sell any stock. Nothing published by Physician’s Money Digest should be considered personalized investment advice. Physician’s Money Digest, its writers and editors, and Intellisphere LLC and its employees are not responsible for errors and/or omissions.