It’s Time to Retire the Myth that Nobody Can Beat The Market

myth- beat the market

Let me stipulate up front that beating the market is not a rational goal for most investors. But it's not because it can't be done, which is what the investment profession will tell you. Even the revered Warren Buffett says it. He has good intentions, and he's partly right. 

It's very hard to beat the market with any kind of consistency, but it can be done. I don't recommend it as a primary goal for investors, but let's face it - almost everyone wants to beat the market, either openly or in secret. It's a challenge, like climbing a mountain or running a marathon or winning at Jeopardy. There's nothing wrong with that, as long as it doesn't become an obsession. That will surely lead to all kinds of bad things, like taking too much risk, swinging for the fences, and even defenestration in extreme cases.

Be Reasonable About It

One way to take on the challenge of beating the market without becoming obsessed about it is to put 80% of your assets into a reasonable strategy that suits your personality and your most important investment goals. Then take the other 20% and put it in a separate box. Call it your "beat box." That way, if you don't know what the heck you're doing and you blow yourself up, you won't end up living in your car during retirement.

But here's the deal. You can't just hop from one beat-the-market scheme to the next, bailing out after a few disappointing months of performance. If you do that, you will never lay down long-term roots, and you have to do that if you want to succeed. 

This doesn't mean that you can't make adjustments along the way. You can tweak things, adapt to changing market conditions, and play defense when necessary. But don't jump from one system to the next, based on your emotional reaction to short-term results.

Strategies That Work

Now that you have your nest egg safely tucked away in a ring-fenced strategy that is designed to get you over the finish line in good shape, let's consider a few ways to deploy your beat box money that won't blow you up. These are strategies that I have used with clients for many years, and I know from firsthand experience that they work - most of the time. That is, they work if you are willing to make a commitment to sticking with them for long enough to give them a chance to work.

Moving average crossovers

This is one of the oldest and most popular ways to beat the market. It's very simple. When the market crosses below the 10 month moving average from above, play defense. Move to 100% cash, or 50% cash, or buy some protective puts, or buy an inverse ETF. How you choose to play defense is up to you, but the moving average crossover is your signal to take action.

This strategy works because it's based on a reasonable assumption, which is that downward momentum in the market tends to continue, just as upward momentum does.

Recession avoidance

Economic recessions are a fact of life, and there's no way around them. And they cause more damage to stock market investors than any other macro event (other than someone in power hitting the nuke button in a fit of anger). In spite of what  you may have heard, there are ways to know, with reasonable confidence, when an economic recession is about to hit. The idea is to use this as another signal for you to play defense.

Shameless plug

I publish a monthly newsletter that includes a recession-warning model that has correctly called every turn since 1957, with no false signals. I don't have a monopoly on this kind of model, but I know that mine works. But that's not why I'm writing this. I have something even better up my sleeve: Factor-based investing.

Factor-Based Investing

A factor is a characteristic that is common to a group of stocks. For example, momentum. At any given point in time, there is a subset of stocks that are rising (or falling) at a faster clip than the market. These are momentum stocks. There are ETFs out there that focus on these stocks, to the exclusion of others. It's a robust factor strategy that you might want to explore.

Another factor is size. History tells us that small cap stocks outperform their large cap brethren by a significant margin. There are ETFs that try to capture this advantage.

Low volatility is another one. These tend to be larger companies that move up and down in price more modestly than the market. 

Quality is another one. Quality is hard to define, but there are ways to screen for the characteristics that high quality companies have in common.

How to Capitalize on the Factor Phenomenon

You can do your own research into the factor universe, and decide which of them suit you. Then you can research the ETFs that represent these factors. Or you can let someone else do the work for you, and just follow their instructions. It's a matter of personal preference.

Shameless plug #2

I have been using factor-based strategies with my clients since 2005. Again, I don't have a monopoly on this strategy, but I know mine works. Below is my complete performance record since 2000. The returns prior to 2005 are from back testing. The rest are actual results achieved by real clients.

The first table shows the returns of all my model portfolios in 2017. The first column shows the name of the model. The second column shows the model's return for 2017. The third column shows the amount of Alpha that each model produced.

The top performer was Smart Money, with a 57.2% return. The worst performer was my Zen Top Ten, which lists my favorite stocks for the coming year, and sticks with them throughout. The Zen Top Ten earned a decent 13.4% return, but it did not beat the market.

2017 factor based model returns

The next table shows the complete record of my model portfolios all the way back to 2000. You can see the return of the S&P 500 on the last line of the table. There are two things I want to highlight here. One is that over the entire 18 years, all of the models have beaten the market, and some of them by wide margins. 

The second thing is that in any given year, each model has the ability to lag behind the market. The volatility of the model returns (the beta) is well above 1 in most cases. That's why it's advisable to limit your exposure to just 20% or so. You can do more than that, of course, but if you do, I suggest that you spread your capital among more than a single model. A diversified approach to factor investing is as important as it is in any investment approach.

full record of model portfolios

Final Thoughts

There are other ways to beat the market, in addition to the ones I've discussed here. But making a decision to pursue this as your only, or primary goal is risky. I encourage my clients to diversify in every way. Asset classes, countries, fund objectives, individual securities, and even strategies like factor-based. 

Everything in the market is cyclical. Stocks, sectors, industries, styles, and factors all go in and out of favor, and it's tough to predict what's coming over the next year or two. Another ironclad rule of investing is reversion to trend. We see it happen repeatedly, in real time. Something catches fire, then investors pile into it, and eventually it becomes a bubble. All bubbles eventually burst, and that's reversion to trend at work.

About the Author

Former head of equity trading, Northern Trust Bank, Chicago. Teacher, trainer, mentor, market historian, and perpetual student of all things related to the stock market and excellence in investing.

Joe DeLong

My one question is the results you show on the Zen Top 7, which are monthly picks, can vary widely by buy and sell prices. A stock can move 5-10% in a day. Everyone buys and sells at different times and price. Your seven picks are bought at market open first day of the month, and sold at market close, end of month?

Erik Conley

Not exactly. Each subscriber can choose his or her own entry and exit time, but for purposes of consistency I show the closing price on the 4th Friday of each 4-week run for both buys and sells. Most subscribers will sell the old names and buy the new names at or near the opening on the following Monday. This is because I don’t send out the newsletter until Saturday, and you won’t know whether any of the new names are holdovers from the prior run.

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