The goal of most active investors is to "beat the market," where the "market" is defined as the total return of the S&P 500 Index. After fees and costs, most investors fail to top the index, but some do, including famous investors like Warren Buffett and Carl Icahn. In this article, we look at what it means to beat the market, some strategies with the potential to beat it, and why it's so hard to do for many investors.
Why The S&P 500?
The typical benchmark that most investors compare themselves to is the (VOO). One reason is that the S&P 500 represents a large portion of the market capitalization of American companies and you can invest in it through an with a few clicks. So, if you're not beating it by picking stocks, you're probably wasting your time. Mutual funds are similarly measured against the S&P 500 because they're long-only and designed, in most cases, to have 100% equity exposure.
It's not prudent to benchmark your entire portfolio to the S&P 500. If you own bonds in your portfolio, they're generally designed to provide capital preservation and income, not to beat the return of the S&P 500. For this reason, stock/bond portfolios may want to benchmark to the 60/40 Vanguard Balanced Index (VBIAX).
Key Takeaway: Another way to think about this is that it's smart to compare only the equity portion of your portfolio to the S&P 500.
How Beating The S&P 500 Works
In Warren Buffett's 2005 annual letter on the Berkshire Hathaway website, Buffett shares the now-famous parable of the Gotrocks family (the parable starts with the section entitled "how to minimize investment returns"). Buffett explains that the total return available to investors is what the underlying businesses earn over time (this is a roundabout way of saying the return of the overall index).
To earn above this (known as Alpha in finance), you have to trade, meaning you earn a higher share of the return, and someone else earns less because they sold to you at a low price. This introduces costs, in the form of fund management fees and commissions, and also generally stops you from deferring your taxes on gains. Buffett argues that these costs take up as much as 20% of the amount of what investors could earn simply by owning the index.
What's more, beating the market is a zero-sum game before fees and a negative-sum game after, like a poker game where the house takes a rake. For one to outperform the market, someone else has to underperform, and a broker gets commissions (and/or payment for order flow) from both sides. The late Jack Bogle argued that, in investing, you get what you don't pay for—performance comes and goes but fees roll on forever. Source: johncbogle.com
Who 'Beats the Market'?
Like in poker, players lose due to the rake in the aggregate. There are plenty of institutional investors who make their living in the stock market and only a minority of them handily beat the market. So who beats the market?
- Bank trading desks, market makers, and high-frequency traders are consistent money-makers. They generally profit from the spread between the bid and the ask in stocks, and profit from the bid-ask spread and the spread between implied volatility and actual volatility in options.
- Investors with high levels of sophistication are able to beat the market.
What Percentage Of Investors Beat The Market?
It's difficult to tell what percentage of investors beat the market, but nature offers clues. Pareto distributions are common in economics, where 20% of X gets 80% or more of Y. For example, 20% of stocks have been shown to get nearly all of the returns in the stock market (The Capitalism Distribution).
The evidence suggests something similar is going on in terms of who gets Alpha in the stock market. Studies show that anywhere from 90-95% of mutual funds underperform the S&P 500 index (ifa.com), or their respective mid-cap or small-cap index. The numbers for retail investors are similar (ssrn.com).
Note: It's worth bearing in mind that mutual funds may not attract the best managers due to restrictions on the type of trades they can do and the higher compensation available for top talent at hedge funds and proprietary trading firms.
Barriers To Beating The Market
Why do retail investors and professionals do so badly at investing in stocks?
1. The Disposition Effect
Folk wisdom for investors is to cut your losses and let your winners run, but research shows that both retail investors and mutual fund managers consistently do the opposite (ssrn.com). Most investors are not aware of this bias, but research shows it costs investors 5-6% annually in returns, as investors sell their winners (which generally keep going up), while holding their losers to wait for a turnaround (which tend to keep going down).
Key Takeaway: An important separator between those who make money in the markets and those who don't is whether they cut losses and let winners run. Also, the tax situation and the economics here are completely aligned, as taking losses gets you tax losses, while gains can often be deferred.
2. Popularity Bias
Research shows that stocks with lower valuations, less popularity and less volatility have better risk-adjusted returns over time. The best performers are not SPACs, cannabis stocks, electric car stocks, space exploration, or any of the "hot sectors" that investors have flooded money into. Instead, they're quiet operations that fill needs for consumers or businesses.
Sources: thinkadvisor.com; spglobal.com
3. Overconcentration and Overleverage
Another related issue with retail investors is that they tend to overconcentrate in certain sectors, especially high-volatility names like automakers, travel stocks, and tech. The typical stock that retail investors buy has volatility higher than average, leaving them susceptible to downturns. Many retail investors amp this up by using margin heavily (and overpaying for it), overtrading, and using call and put options heavily to express their views on stocks.
Examples of Investments That Beat The S&P 500
Warren Buffett and Jack Bogle argue most investors are better off investing in index funds. But there are plenty of pros who have beat the market over time, including Buffett himself.
Common ways this is done are by:
- Value Investing: buying assets under their true value and selling them higher than their true value
- Activism: buying shares in companies and then forcing them to run their businesses better
- Arbitrage: trading correlated or connected assets long and short
- Carry: borrow money cheaply and lend or invest it at higher rates
Some examples of past investments that have beat the market (note that this list doesn't imply that these stocks will beat the market in the future):
Stocks That Have Outperformed The Market
1. Altria (MO)
When Wharton professor Jeremy Siegel went to study which stocks had returned the best over the previous century, he found that tech stocks weren't the highest performers (amzn.to), although some had done quite well. Instead, he found that tobacco stocks were the most profitable investments over time, delivering solid results with a continually low valuation. This was in contrast to high-flying tech stocks, many of which went out of business or were acquired by competitors for a low price. Investing in tobacco is not ESG, but it's the sector that has delivered the highest returns for investors over time. Whether this will be true in the future is anyone's guess, but the valuation remains low for Altria and the cash flow remains solid.
2. Monster Beverage (MNST)
Monster Beverage stock has blown Apple (AAPL) out of the water over the course of its existence, delivering massive growth over time. In addition, the stock has had a better risk-adjusted return as well. Apple has performed better than Monster over the past few years, but this gap may narrow as tech falls back while people keep chugging along buying energy drinks. Monster is discovered now-it's unlikely that the company will be able to keep pace with its incredible gains going forward, but it's an example of how a small investment in a company that hits it big can make you rich. There's nothing magic about Monster either, just a great return on equity and a long runway for growth.
Funds That Have Outperformed The Market
1. PIMCO StocksPLUS Long Duration (PSLDX)
PSLDX is an example of a fund that uses the carry strategy. Essentially what they do is invest their portfolio in 100% stocks and 100% bonds, using the highly efficient futures market to essentially borrow funds at the rate that cash pays. The fund is based on a super simple premise, which is that a mix of stocks and bonds rebalanced periodically will outperform cash over time. PSLDX has been hit hard by the current rate shock, but going forward it should offer a return that can beat the S&P 500 over time. Note that PSLDX is very yield-heavy due to regulations on paying out returns, so you're best comparing returns using a tool like Portfolio Visualizer rather than looking at the price graph, which can be misleading.
2. ARK Innovation ETF (ARKK)
Cathie Wood's Ark Innovation Fund is worth talking about as well because it illustrates the way some active managers rise and fall, and because it was the best performing ETF in America, until recently.
Ark rode the wave of speculative tech, investing in work-from-home companies, electric car stocks like Tesla (TSLA), and Bitcoin (BTC-USD). These are all real trends, but investing in growth at any price and over concentrating the portfolio has led to a stunning reversal in ARKK. As they say on TV, past performance doesn't guarantee future results!
Hedge Fund Managers That Have Beat The Market
1. Ray Dalio
Dalio runs Bridgewater Associates, which is the world's largest hedge fund by most measures. He invests using a strategy similar to PSLDX in some ways, by taking positions in stocks, bonds, commodities, and real assets to provide returns in the vast majority of market environments. Some strategies they use are risk parity and volatility targeting, and unlike many funds that are secretive, Bridgewater is happy to talk about its approach with the media and write about it in academic papers. AQR is another large hedge fund that publishes quality research in related areas.
2. Warren Buffett
For the uninitiated, Warren Buffett runs Berkshire Hathaway and is one of the most successful investors of all time. Buffett is known for his long-term approach and for his clever use of Berkshire's insurance operations to get cheap capital to make investments. Buffett is also a great dealmaker.
3. Carl Icahn
Icahn is different from the first two managers, preferring a rough and tumble activist style in his investments at Icahn Enterprises. A classic Icahn strategy would be to find a company that's poorly run, build a position, wage a campaign to replace the management, make the necessary changes, and sell his shares for a healthy profit.
4. James Simons
Simons may be the most mysterious of all, but his team uses mathematical models to predict changes in prices and trade and has the highest returns of any hedge fund manager I've studied. Simons' main fund at Renaissance Technologies is regarded by many to be the best in the world.
Can An Individual Investor Beat The Market Consistently?
Yes, you can. But you're not likely going to beat the market without being lucky, good, or both. Just as you probably wouldn't expect to get the body of your dreams without ever visiting the gym, it's difficult to beat other participants in the financial markets without being educated.
Finding investments that can beat the market is the raison d'etre of Seeking Alpha, and here you can follow a variety of authors and commenters who periodically share their ideas. For many investors, the right choice is to put all of their money in index funds and chill out. But if you have the time and interest, are able to understand common behavioral biases and asset pricing anomalies, and have a steady hand, you can give yourself a shot at being among the minority of investors who reap a majority of Alpha in the market.
Bottom Line
Beating the market isn't a piece of cake, but it is doable. The financial markets are among the most heavily studied topics in the world, so the best first step for investors is to read as many academic papers, books, and articles about the financial markets as they have the time and inclination to do. The reward for doing this is not linear to your effort, but rather exponential due to compounding.
Analyst’s Disclosure: I/we have a beneficial long position in the shares of MO either through stock ownership, options, or other derivatives. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.
Seeking Alpha's Disclosure: Past performance is no guarantee of future results. No recommendation or advice is being given as to whether any investment is suitable for a particular investor. Any views or opinions expressed above may not reflect those of Seeking Alpha as a whole. Seeking Alpha is not a licensed securities dealer, broker or US investment adviser or investment bank. Our analysts are third party authors that include both professional investors and individual investors who may not be licensed or certified by any institute or regulatory body.
As a seasoned expert in finance and investment, I bring a wealth of knowledge and experience to dissect the concepts embedded in the provided article. My expertise is grounded in a comprehensive understanding of financial markets, investment strategies, and the nuances of active portfolio management.
The article revolves around the central theme of "beating the market," with the market defined by the total return of the S&P 500 Index. Let's delve into the key concepts and insights presented in the article:
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Benchmarking Against the S&P 500:
- The S&P 500 is a widely accepted benchmark for investors, representing a significant portion of the market capitalization of American companies.
- Investors often compare their performance against the S&P 500, and mutual funds, being long-only and equity-focused, are measured in a similar fashion.
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Warren Buffett's Perspective:
- Warren Buffett's 2005 annual letter introduces the concept of earning "Alpha" by trading and explains the costs associated with active trading, including fund management fees and commissions.
- Buffett argues that the costs incurred by active traders can significantly erode potential returns, estimating as much as 20% of what investors could earn by simply owning the index.
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Who Beats the Market:
- Institutional investors such as bank trading desks, market makers, and high-frequency traders are noted as consistent money-makers.
- Investors with high levels of sophistication are identified as those who can beat the market.
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Percentage of Investors Beating the Market:
- Pareto distributions are referenced, suggesting that a small percentage of investors achieve the majority of returns.
- Studies indicate that a significant majority of mutual funds and retail investors underperform the S&P 500.
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Barriers to Beating the Market:
- The Disposition Effect is discussed, highlighting the tendency of investors to sell winners too early and hold onto losers.
- Popularity Bias is noted, emphasizing the superior risk-adjusted returns of stocks with lower valuations and less popularity.
- Overconcentration and Overleverage are identified as issues, particularly among retail investors.
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Examples of Investments That Beat the S&P 500:
- Different investment strategies are mentioned, including value investing, activism, arbitrage, and carry.
- Examples of individual stocks (e.g., Altria, Monster Beverage) and funds (e.g., PIMCO StocksPLUS Long Duration, ARK Innovation ETF) that have outperformed the market are provided.
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Hedge Fund Managers Who Beat the Market:
- Notable hedge fund managers such as Ray Dalio, Warren Buffett, Carl Icahn, and James Simons are highlighted for their success in beating the market.
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Can Individual Investors Beat the Market:
- The article acknowledges that individual investors can beat the market but emphasizes the challenges, citing the need for education, understanding biases, and having a steady hand.
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Bottom Line:
- Beating the market is portrayed as achievable but challenging, requiring education, understanding of behavioral biases, and a disciplined approach.
- The importance of reading academic papers, books, and articles about financial markets is underscored.
In conclusion, the article provides a comprehensive overview of the challenges and strategies associated with beating the market, drawing on real-world examples and the insights of renowned investors.
