Every investor wants to try to “beat the market.” By “beating the market” investors usually mean that they want to do better than some index or average. After all, who wants just “average” or “below average” performance in their investments? So many investors devote much time and energy to doing better than some index. How do you beat the market? Is it even possible?
First, it is important to understand what makes up the “market.” Common stocks are bought and sold in a variety of ways, both here in the U. S. and overseas. Some stocks are sold on exchanges, like the New York Stock Exchange. Others are traded in the Over-the-Counter market which is really a network of securities firms that bid for the purchase or sale of a stock. A number of averages have been created to gauge how the markets for common stocks are doing. These averages or “indexes” measure different aspects of the total market for common stocks. Beating an index would seem to be a fairly simple matter. Indexes are, after all, merely mathematical formulas. One would expect that with the careful selection of stocks and proper timing of the market, it ought to be fairly easy to “beat the market.” However, it is in fact extraordinarily difficult to beat the market consistently over a long period of time. Professional money managers, very often do not beat the market indexes.
There are a number of people, mostly college finance professors, who will tell you that it is simply impossible to beat the market indexes. These people believe in the “random walk” theory and the “efficient market” theory. The random walk theory says that the stock market moves randomly and that you can’t predict the future of the market by looking at the past. Here’s an easy way to understand the random walk theory. Imagine there are 1,000 people all with quarters and we ask each person to flip their coins. Every time they flip “heads” they win and get to flip again. If they flip tails, they lose and must stop flipping. After 50 flips there are, say, only 20 people left of the original 1,000. Clearly, these people are not “good coin flippers” and they are no more or less likely to flip heads on the 51st than they were on any of the first 50. This is a random walk.
The efficient market theory basically holds that information about common stocks today is so widespread and so widely known that all good or bad news is almost immediately reflected in the price. It is, therefore, impossible to find a stock to buy for less than what it is truly worth. If all stocks are always fairly priced and move randomly, then managers who hold a diversified portfolio will never be able to beat the indexes. In other words, despite all of their education, training and experience, the managers will be no more successful over the long run than a monkey who picks stocks by throwing darts at the newspaper stock quotes. Naturally, a number of investment professionals dispute these theories. Investment pros point to the long-term (almost half a century) track records of people like John Templeton, Peter Lynch, Warren Buffet and others. The existence of these extraordinary managers who have beaten the indexes over many years and through many different types of markets and economic conditions disproves the absolute application of the efficient market theory.
How can the investor profit from this? First, because the markets are so unpredictable, don’t try to “time” the market. Second, in some cases you may not want to beat the market. Stock markets go up and down. It’s the downs that investors find unsettling. The market doesn’t care how high or how low it goes. You should care. The best way to manage this risk of investment is through diversification. That means that you should own more than one stock or bond. It also means that you should own more than one type of asset. Applying the concept of diversification to owning more than one type of investment is called “asset allocation.” Wise investors divide their assets between stocks, bonds, real estate and other investments. Given the nature of our global economy, it makes sense to consider foreign investments as well. A long-term orientation is also essential. For a stock investment, that means a 3 to 5 year commitment.
The final lesson to be learned is the importance of working with a professional advisor and professional money management. Professionals have the time, training, and temperament to spend their working lives seeking to produce superior returns while managing risk.