Thoughts on beating the market

Investment returns

You don’t have to be a genius, just disciplined

It can be said off the bat that no investment decision should ever be motivated by trying to beat the market. The moment this impulse creeps in, the investor is liable to risk seeking behavior. Risk seeking behavior is when we take risks that are not warranted by the expected return.

Our goal as investors is quite simple: John Templeton taught: “For all long-term investors, there is only one objective-“maximum total real return after taxes.”” (Proctor & Phillips, 1983, 2012)p.153. ‘Total returns’ include dividends as well as price changes. A ‘real return’ is the return calculated after adjusting for inflation.

As Ben Graham wrote: “To achieve satisfactory investment results is easier than most people realize; to achieve superior results is harder than it looks.” (Graham, 1973) p. 287 (emphasis added). What I have always sought is ‘superior’ returns.

I didn’t set out to beat the market. It just happened. With the benefit of hindsight, our family’s superior investment performance over the last 47 years (see About) was realized because I followed what Ben Graham called ‘sound principles of operation’.

In over 45 years of investing I have invested almost exclusively in common stocks and will continued to do so. This worked for me while building capital during my working years, it has worked for me since retiring and it will, with luck, work for me for years to come. The simple reason I focus on common stocks is that they outperform all other asset classes over the long haul; they provide the ‘maximum total real return after taxes’. The idea is to maximize your returns and then live within the returns your skill and luck dish up.

Stocks are in many ways less risky than bonds because the route to superior stock returns is to invest in superb companies. With bonds the route to higher returns is to invest in more risky securities. As well bonds are risk prone when it comes to inflation.

I firmly believe the stock market is essentially inefficient. I would put it this way: the market is value inefficient because of Mr. Market. For individuals and pro’s alike, markets are hard to beat because of our human frailties. Ironically, in many ways, the stock market is essentially inefficient because investors believe it is efficient; i.e. they tend to think the price is right, which is why they get things wrong.

When we started saving for our retirement in the early 1970s, there was no such thing as index funds. Index funds will give investors ‘satisfactory’ returns. The vast majority of investors should invest in a simple S&P 500 index fund and leave the money there. They should not invest in sector ETFs.

The main drawback with index funds is that one cannot practice value investing with index funds. Value investing involves investing in superb companies when their price is temporarily depressed. This happens regularly through the stock cycle, not only when there is a general bear market. Some funds claim to value invest by investing in value stocks. They do not value invest. But that is another story. However, investing in index funds you can’t beat the market.

So, can you beat the market? If the S&P 500 were a portfolio it would be thought hopelessly over diversified and filled with a lot of underperforming companies that would be pruned by a competent fund manager. The stocks in the S&P 500 are chosen by a McGraw Hill Financial S&P index committee based on standard criteria such as market capitalization, liquidity, public float, sector balance, financial viability and domicile. Looked at this way one would think it not too difficult to outperform such a portfolio.

The main advantage the index has over investors, whether individual or professional, is that the S&P 500 doesn’t suffer from market psychology/behavioral problems because it doesn’t buy and sell in the usual sense. Stocks are added and removed from the index based on fairly objective criteria. The market index doesn’t try to time the market.

Investors seeking superior returns should learn how to invest in individual common stocks. This involves study and practice. The study will teach ‘sound principles of operation’. It will also help in dealing with the behavioral gap. Ultimately, one has to attend the school of hard knocks; learning by doing.

And track your performance. Since luck plays such a large role, it would be entirely possible to beat the market over say, ten years, essentially by luck. See my post on identifying gurus, here. Beware of over-confidence. By the same token, one should not get discouraged by a number of years of under-performance. It could be bad luck. If it goes on much over ten years it might be a sign that a switch to index funds is in order.

Want to read more about the issues raised in this post, take a look at Part 1: The Field of Play, particularly Chapter 3. Is it Possible? and Chapter 12. Short Term Thinking and our Flower Garden and Section 12.01 Defining terms. Also look at Part 4: Principles of Operation and particularly Chapter 27. Sound Principles of Operation.

Want to dig deeper into the principles behind successful investing?

Click here for the Motherlode – introduction.

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