Simply put, if an investor such as an individual, portfolio or fund manager earns a return that is better than the market return, that person has beaten the market. For example, if the market is up 3% and the investor has earned a 7% return, then that investor can be said to have beaten the market.
But first, an explanation of “the market” that most people refer to is in order.
The market: S&P 500 index
Introduced by Standard and Poor’s in 1957 the S&P 500 index tracks the value of 500 large corporations listed on the New York Stock Exchange (NYSE). Corporations included in the index are used to represent the overall composition of the U.S. economy and is considered to be a leading indicator of its health.
Adjusted for inflation, the average annual return for the S&P500 is about 7% and investors can mirror this return by investing in an S&P 500 index fund. Also known as passive investing, these funds simply invest in the companies included in the index.
In reality, investing in an S&P 500 index fund would return less than the S&P 500’s average annual return after accounting for frictional costs. These frictional costs include management fees, trading costs and taxes.
With frictional costs making it difficult to earn the same return as the market, is it even possible to beat the market, and do it consistently?
Beating the market
A simple Google search will yield a multitude of strategies that enable investors to consistently beat the market. These strategies can generally be grouped under the umbrella of active investing. Active investing strategies usually involve investors or fund managers actively picking stocks to invest in by first evaluating them through technical analysis or other means.
The evidence however, is against active investment.
According to the S&P Dow Jones Indices Persistence Scorecard released by in January 2016, only 7.48% of large-cap funds consistently outperformed the market over 5 consecutive 12-month periods. That’s a staggering 92.52% that failed to outperform the market.
Why the market is beating you
As mentioned, frictional costs such as management fees, trading costs and taxes have to be subtracted from your investment return. Moreover, management fees for active funds tend to be higher than that of passive funds. The premium goes to the active fund manager who supposedly has the expertise to pick stocks that will outperform the market. In essence, if you’re looking to beat the market, you’ll have to earn a return that more than compensates for frictional costs.
The second barrier to beating the market is based on investor psychology. When the market is up, investors tend to buy so that they can get in on the action and excitement. Conversely, when the market looks bleak, there is a tendency for investors to sell and preserve their remaining assets.
This “buy high, sell low” behaviour means that investors could be buying into the stock market on the verge of a downturn, or selling before the market recovers – not a good strategy for outperforming the market.
The luck of the draw
Bearing the above in mind, you’re more likely to beat the market through luck. But what about the Warren Buffetts of the investment world?
While Warren Buffett may be a financial wizard who has made a fortune by picking stocks using an active investment strategy, he probably belongs to the 1% of active traders who actually outperform the market as researched by Brad Barber from the University of California Davis, and Terrance Odean from the University of California Berkeley. Hence, Warren Buffett’s stock picks could be attributed to being extremely lucky.
So, what investment strategy is best in the long run? A paragraph from Warren Buffett’s 2014 annual letter to Berkshire shareholders may just have the answer:
“…Put 10% of the cash in short-term government bonds and 90% in a very low-cost S&P 500 index fund… I believe the trust’s long-term results from this policy will be superior to those attained by most investors — whether pension funds, institutions or individuals — who employ high-fee managers[BL1] .”
In essence, trying to consistently beat the market would most probably lead to a futile investment of effort and time. For most retail investors, a better strategy – if you don’t have the time, effort and expertise – would be to take the passive approach and invest in an S&P 500 index fund. You won’t be beating the market, but 99% of people won’t be doing so either.