Few things are as alluring as beating Wall Street. Whether you’re a slow-going Buffett fan or a fanatic of in-and-out trading and influence George Soros-style, the idea of beating the market averages over the long term is what any investor wants to do. Beating the index marginally…say, by 1% a year for 20 years, makes a huge difference in total returns. However, beating the index reliably and over the long term isn’t as easy as shaving an extra 1% from the market each year. Every investor wants to do it, but should you try to do it? And if you want to beat the index, what are the more reasonable ways to do it?
What Beating the Index Means
Beating your index means generating higher returns relative to the risk you take on. Risk is accepted to mean volatility, or the amount your balances “wiggle” from day to day. Small cap stocks are more volatile, having higher peaks and lower troughs, and are thus riskier than large cap stocks. Thus, investors who have more exposure to small caps tend to beat the returns of large caps. However, they accept more volatility risk for doing so. Volatility is measured by beta. The Russell 2000 index of small cap stocks has trumped the returns of the S&P 500 index over time. However, the Russell 2000 index is more volatile, having a beta of 1.2 vs. a beta of 1 for the S&P 500 index. Investors who owned small cap stocks beat the index if you only look at the S&P 500 index. However, on a risk-adjusted basis, small cap stocks didn’t beat small cap stocks – the best comparable to the Russell 2000 index is the Russell 2000 index. Investors who owned the whole Russell 2000 index beat large caps, but they didn’t beat small caps. If your sole goal is higher returns, opt for more volatility risk.
Higher Returns: work vs. risk
There are only two ways to get higher returns. I’ve covered one: simply taking more volatility risk for a bigger total return in the long-run. This is the most reasonable way to get a higher return on your money. It’s not beating the index, although it achieves an ideal result: getting a higher return. The alternative is serious and time-consuming research into individual investment ideas. Investors who can select individual stocks with return profiles that beat and exceed their risk can generate above-market returns in the long-run. However, one must consider the skills and time required to search for individual stocks. Analysts who research stocks as a full time job have to investigate everything about a company. This includes:
- Meeting with C-level executives.
- Visiting and talking to a company’s customers and suppliers.
- Going to company stores and doing a “channel check” to gauge sales pace and project earnings.
- Reading thousands of pages of financial reports. (The average company publishes more than 400 pages of quarterly and annual reports each year.)
- Comparing research with similar companies in the same industry.
- Understanding and decoding complex corporate accounting.
- Assigning a value to a company based on all of the above due diligence.
After doing all this work totaling hundreds of hours, all this work might point to a simple disappointing reality: a company isn’t investable. Can the average part-time investor keep the pace with people who have this skill set and access to key information? Not very often. When one considers the amount of time and knowledge necessary to understand a company from top to bottom, most find that their time is better spent elsewhere.
Returns on Time
The fastest, easiest, and most reliable way to get a higher return on your capital is to accept more risk. The trade-off is having to deal with the occasional heart attack, when more volatility works against you, not for you. Given the amount of time it takes to properly analyze an individual stock, individual investors are better off using that time for other productive resources. Consider this: someone who puts away $1,000 for retirement will likely always beat the performance and end result of someone who only socks away $500 per month. If the choice is between saving more or saving less and spending more time investing, the best option is almost always to spend less time investing and more time making money. Beating the index, though improbable, takes dedication. Few people know that Warren Buffett, one of the few people to beat the index over very, very long periods of time, basically ended a marriage because of how much time he dedicated to individual stocks. Far many more people dedicated just as much time, perhaps even more, and yet failed to beat the index…those people are simply forgotten. All in all, the quest for market beating returns isn’t worth the time to do it for 99% of market participants. If your goal is higher returns, opt for more volatility or bigger contributions to your savings. If you want to have some control over your retirement, consider a “play money” account – you can have as much fun and control over this account as you want, but it’ll never threaten your future financial goals while you do so.