How Can I Beat the Stock Market?

pf101You’d be surprised how often I’m asked some variation on this question. People will write in to me asking me whether they should buy an index fund (in other words, they would own a little bit of a LOT of stocks and ride the averages of the stock market), a managed mutual fund (where someone else actively chooses stocks for them), or whether they should just pick stocks for themselves. They’ll ask me my opinion on various investments and investment advisors.

Really, in the end, their questions come down to one issue. Can I beat the stock market and earn a greater return for my money than I might get in an ordinary index fund?

The answer is yes, of course you can, but the ability to do so isn’t that simple.

Here’s how I like to explain it. Let’s take 1,000 random people who have at least some money invested in the stock market, whether in their retirement funds or otherwise, and give them each $100,000 to invest in the stock market.

At the end of the year, if you added up the market value of all of those investments and compared it to the total amount you started with ($100,000,000), the amount of total growth would be about the same as the overall stock market.

That makes sense, right? Some of those investors will do better than the market. Others will do worse. A lot of them will tread water and roughly match the market.

It’s really not all that different than filling out an NCAA basketball tournament bracket. Very few people will miss all of their picks, and very few people will pick the Final Four completely right. Some of the picks will seem easy (a 1 seed versus a 16 seed) while others will be very tricky (an 8 seed versus a 9 seed). Most people will end up somewhere in the middle, getting some picks right and missing on others. The ESPN Tournament Challenge demonstrates this quite well (I was at the 53rd percentile, by the way, with none of the Final Four picked correctly).

Those people that do beat the market, just like the people who pick the Final Four correctly, show that it is possible to beat the odds. If you know how to do this well, you can certainly make a lot more money than the average investor.

The problem is that very few people can do this consistently over a long period of time.

There certainly are people who have done it in stocks. Peter Lynch and Warren Buffett immediately come to mind.

The problem is that if people have a knack for doing this, they’re often scooped up quickly by the hedge fund or private equity businesses and make an obscene amount of money plying their trade. Individual investors – you and me – don’t have access to their expertise without paying a lot of money, and if you’re like me, you don’t have that kind of money to pay someone for advice. The fees for the attention of someone on that level would obliterate the amount I actually have to invest, leaving me with very little.

Thus, for me, there’s really only two options: doing it yourself or simply buying an index fund and playing the average.

Doing it yourself can be very rewarding. You know exactly what you’re investing in and have control over it. You have the freedom to choose companies to invest in that you actually believe in instead of just pieces of lots and lots of companies. Having the right handful of companies can certainly beat the market – just ask anyone who bought Google in 2002.

One problem is that doing it yourself can also be a big time sink, especially if you’re trying to maintain some degree of diversity, which you should be (Diversity simply means that you own lots of stocks of companies in unrelated sectors, like owning stock in Coca-Cola, Nike, and DuPont all at the same time, which is good because if something affects Coca-Cola’s bottom line, it shouldn’t have much of an impact at all on Nike or DuPont). You have to invest the time to study a lot of companies, make the decision as to which ones to invest in, and then keep a constant eye on them.

Another problem is that with those rewards comes risk. The smaller the number of stocks you’re invested in, the greater the risk of being hurt by a slump in one particular economic sector. The larger the number of stocks you’re invested in, the more time you have to devote to simply managing your stocks.

My advice generally is this: if you’re passionate about stock investing and are willing to take on some additional risk for some additional reward, individual stock investing can be worthwhile and you can sometimes do better than the stock market. However, if individual stock investing isn’t something that excites you, don’t. Invest in an index fund and you can just ride the average due to owning a little bit of lots of companies.

Of course, no one says you can’t do both. An old friend of mine has most of his money locked up for retirement, but he keeps about 5% of his paycheck aside to invest in individual stocks. He mostly buys stocks that he understands that pay a high dividend. His stocks rarely shoot up in value, but he does receive some nice dividend checks. Plus, it’s a great hobby for him that isn’t sinking his future.

That’s the biggest win of all, perhaps.

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