Updated on 09.15.14

How Can I Beat the Stock Market?

Trent Hamm

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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  1. Josh says:

    Pretty good article although once you start to learn more about appropriate benchmarking the number of people outperforming their benchmark shrinks even further. eventually you realize that even the guys who are the best of the best are generally not keeping up with their APPROPRIATE benchmarks over long time horizons and if they can’t do it with millions invested in research all the little guy has is luck. It can be fun just like playing the lottery but one wouldn’t count their portential lottery winnings toward retirement savings.

    The last thing to note is that returns need to be looked at net of fees, taxes, and expenses. Dividends sound great until you realize they are just forcing you to realize a tax burden every year rather than defering taxes through cap gains which in effect is borrowing free tax money from the government that forces the government to share in any losses.

  2. Johanna says:

    If you’re passionate about stock investing, and you’re such a stock-picking genius that you can consistently beat the market, then get a job picking stocks with other people’s money – that’ll make you a lot more money than you’ll ever get just investing your own.

  3. Des says:

    This is actually a nice, well-balanced article. I would have expected Trent to be like other PF bloggers with the “you’re an idiot if you don’t buy index funds” mantra. I’m pleasantly surprised :)

    One thing I would like to see addressed in articles like this is that trading with $10,000 is in no way the same as trading with $10 million. People say things like “you can’t beat fund managers because they have more research than you” which shows so much ignorance as to how trading and mutual funds work.

    First, if you’re trading with small amounts, you can move in or out of a position without anyone noticing. No one would ever know when I bought APPL at $117, because I only bought a few shares. When a prominent fund manager makes a move, everyone knows because they are throwing millions of dollars into it. They have to employ tactics to move slowly in to and out of their positions so as not to greatly alter the share price too quickly and cause a frenzy. Most individuals have no such restrictions on their trades. If you can see where the big guys are headed before they’ve completed their move, you can piggy-back on their knowledge.

    Second, and perhaps more important, mutual fund managers are not paid based on performance. They are paid based on how much money is in their portfolio. They are sales-people first, traders second. There is a strong incentive for them to do what everyone else is doing. If they succeed conventionally, they win. If they fail conventionally they still win (because everyone else is going down, too). If they succeed unconventionally, they’re a genius. If they fail unconventionally, they’re fired. There is a strong incentive to be conventional.

  4. +1 for #3 Des.

    I invest in individual dividend growth stocks.
    I invest in those businesses and markets that I understand. (Canada and the United States). For international diversification, I utilize ETFs.

    Some years I beat the major indexes, some years I don’t. But, I’m receiving more and more dividend income each year! Businesses can always try to use creative accounting to influence reported results, but they can’t “fake” a dividend payment.

  5. Barry says:

    Nice post I like the way that you give a balanced opinion of the subject. Most people have very strong one sided opinions about this subject.I agree with your advise it is very sound .I would encourage anyone thinking of investing in individual stocks to read several books on the subject before starting and to run a “fantasy portfolio” keeping track of any transaction costs that they would incur until they are confident in themselves.The trick is to out perform the indexes over the long run short term returns are not a good indicator of talent or lack there of .

  6. Pat S. says:

    Fact is, in any sample you will have an average group and outliers. 50% will be above average, and 50% below average. The stock market is no different. If we consider the average the S&P 500, then if everyone had their own personal portfolio of stocks, the chances are 50% would beat the average.

    Here’s the kicker. This system is skewed by the hedge funds and mutual funds who buy such huge amounts of stock that it sometimes means the stock price does not accurately reflect the company’s prospects.

    I believe this is why sometimes you see out performance in small cap stocks. Not because these companies are better run or more innovated than their blue chip counterparts, but because Wall Street just doesn’t have them on radar yet.

  7. Hunter says:

    Fair & balanced overview. While the market is not perfectly efficient, I’m a subscriber to the random walk theory. Lynch’s & Buffet’s might get it right more often than most, but in the long run it’s super difficult to beat the market.

    WRT diversification. International markets must be included in our portfolios to provide additional balance as they often perform differently to the U.S.

  8. Kevin says:

    A fantastic book on this topic is Jack Bogle’s “The Little Book of Common Sense Investing.” It lays out in detail why over the long term, you are far better off taking the average return than trying to beat the market. The “friction” of fees, taxes, brokerage expenses, and everything else far outweigh your potential gains, even if you are slightly above average (i.e., you’d have to be REALLY exceptional to compensate for all those expenses, and still come out ahead of the market average).

  9. getagrip says:

    I like this article, it points out something people don’t like to think about. It takes a lot of time, energy, and effort to get really good at nearly everything and anything. Why would learning to invest be any different? I look at investing in index funds as a low level understanding of investing, kind of like recreational tennis. I know a bit about playing the game and I won’t embarass myself and I can do okay with the knowledge I have. But if I want to really get better, I’m going to have to get some coaching, play a lot more often, and put a lot more effort into learning the details of the game.

  10. Andrew says:

    These are some great points. I completely agree that if you do not enjoy managing your own portfolio or have no idea what you are doing, then you are likely better off just sticking your money in various index funds. However, I commend Trent for admitting that beating the market can be done. The problem with most proponents of indexing is that they fail to admit that thousands of people do beat the markets consistently, and many of these people are individuals solely trading their own money.

    #3 Des made some fantastic points. Individual investors have several advantages over institutional traders. Moving $10,000 worth of stock is a lot easier than moving $1,000,000. Individuals have more flexibility, mobility, and are not constrained by one particular investment strategy in which they are required to adhere. The markets are not completely random or efficient, and stock prices only reflect what the market is willing to pay for a particular company and does not necessarily represent the actual internal value of the company (forget what the professors of the world tell you; they are not traders). As sentiment changes, trends develop, and this is where most of the money is made.

    And for #2 Johanna, managing other people’s money is completely different from managing one’s own. I’ve done it before, and it adds many different elements that can inhibit performance. Great individual traders don’t necessarily make great money managers.

  11. Tom says:

    Nice write-up, Trent

    @#1 Josh – You make an interesting point about the dividends, but there are plenty of tax-efficient (if not tax-free) to collect dividends when investing for retirement (or in general, long term)

    John Bogle makes a solid case for index investing, but I’ve always wondered why no one ever criticizes him for being a biased proponent of index investing since he built a business around it. I guess he’s always had an air of a fiduciary for the client, but when you think about it, he was always basically marketing Vanguard when he gave his opinion on how the masses should invest.

  12. Maggie says:

    I like what you’ve said, as far as it goes, but it applies to more than just the stock market. Bonds are a whole different ballgame, and (at least according to Michael Lewis in “The Big Short”, a book about what crashed the market in 07-08) may be a far bigger ballgame requiring much deeper understanding. Real estate investments, both at the level of ‘local individual building purchase’ and ‘real estate investment trusts’ are a whole different situation. A porfolio that has some of all three can become a huge time sink … and can also ensure a solvent retirement.

  13. deRuiter says:

    If you buy individual stocks in your ROTH, and make money, there is no tax consequences. If you have a passable amount in your accounts (say a ROTH and a regular brokerage account with stocks) with a discount broker, you can negotiate a much chaper cost for your buy and sell commissions.

  14. Josh says:

    If you can make money in the stock market, power to you.

    However, it’s proven overtime that if you can get a small return in the positive every year, with opportunity for larger growth, AND have the ability to use your money at the same time for the things you need like cars etc, you will be in a much better position to gain wealth.

  15. AnnJo says:

    This was a good, balanced and realistic post and some good comments, too.

    Another major advantage the individual investor has over the index fund manager is that the individual investor can tolerate holding a fair amount of his/her portfolio in cash, while the index fund manager generally cannot.

    This means that when it is becoming obvious that the market as a whole or some sector is overheated, an individual investor can liquidate a portion of the portfolio and sit on that money, waiting for a correction, and will have cash to buy more shares when the market does correct.

    Over time, I’ve seen the stocks of certain companies I follow show huge price swings over the course of a few years. I find I can make good money selling a part of a holding when P/E gets too high and yields get too low, and buying it back a year or two later when the stock price has descended from the stratosphere. If I understood puts and calls better, I could probably do the same thing through that mechanism, but I don’t feel competent in that area yet. Since I don’t trade all that much, the fees are nominal, and since I’m dealing generally with a pool of less than 30 companies, I can follow them reasonably well.

  16. tentaculistic says:

    I remember when I was taking the investing classes for my MBA, we read a lot of studies about investing – the net result of which was that I decided not to bother with picking individual stocks. The 1 that stuck out in my mind was a group that has as its control group a wall of stocks and a randomly thrown dart – and the random dart pick did as well or better than the carefully researched stock pick. (thanks to Google, I think the study was the 1988 Wall Street Journal contest, a good summary of which was on the website Investor Home).

    I’m young enough that I go with index funds dialed up to the max in aggressiveness, and just don’t look too often so I don’t get too bothered by ebb and flow over the year. As I get older, I’ll dial down to a safer balance of assets. Maybe I’m just not confident enough in my intelligence/ability to choose stocks, but I figure that would just be hubris on my part.

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