The world of investing is the world of endless choice. You can choose to invest your money in one of many different types of instruments – for example, deposits, bonds, equity, etc. You may also allocate your money to any combination of these instruments. Further, you have thousands and thousands of bonds and shares and deposit opportunities to choose from. In this world of endless choice, how do we assess various choices? In other words, can you judge which investment is good and which is not?
Beating the Market (and Stock Indices) Explained
You may have come across statements like “Warren Buffet has consistently beaten the stock market” or “this fund has beaten the stock market three years in a row”. Beating the market is one measure of how well a particular investment portfolio has performed – to beat the market means to have outperformed the market index. This leads us to another question – what is a market index? A stock market index is simply a measure of the value of a group of stocks.
Suppose you take a group of 10 stocks in a market. The value of these 10 stocks together can be represented through an index. Suppose we construct an index that represents the sum of the values (i.e. the prices) of 1 share of each of these stocks today. So, we assign a number, for example 1,000, to the index to represent the value of these stocks today. In the next one month, suppose the value of these stocks together goes up by 10%. In this case, we will say that the index is now at 1,100 (i.e. 1,000 + 10% of 1,000).
On the other hand, suppose the value of these stocks together goes down by 10%. In this case, we will say that the index is now at 900 (i.e. 1,000 – 10% of 1,000). This is a brief illustration of how a stock index works. In this case, the index represents the value of 1 share each of 10 different stocks. Do note that it is not necessary that each of the components of the index have equal weight.
For example, we can just as easily create an index based on the values of these 10 stocks where the price of one stock (say stock A) has 50% weight in the index, the prices of 4 other stocks have 10% weight each in the index and the prices of the remaining 5 stocks have 2% weight each in the index. In this case, the index will be more sensitive to changes in the price of stock A than to changes in the prices of the other 9 stocks. Similarly, the index would be impacted more heavily by changes in the prices of those 4 stocks that have 10% weight each on the index than by changes in the prices of those 5 stocks that have 2% weight each on the index.
Another point to note is that if a stock market index gains in value, it does not mean that all the stocks that are a part of that index have uniformly gained value. It is possible that some stocks may have lost value, some may have neither gained nor lost value and still others may have gained value. The index only tells us whether the value of the stocks together has increased or declined. It does not tell us anything at all about any of the individual stocks.
Do note that there can be many different kinds of stock market indices. For example, MSCI World and S&P Global 100 are two well-known world (or global) indices. Such indices typically track large companies across the world. These indices provide a measure of stock market performance across the world, i.e. they provide a quick indication of how stock markets (taken together) across the world have performed (whether they have gained value or lost value).
Regional indices, such as FTSE Developed Europe Index, FTSE Developed Asia Pacific Index, etc., reflect stock market performance across various regions or parts of the world. Such regional indices typically cover areas larger than a single country. They may encompass an entire continent or parts of different continents or groups of continents.
National indices, such as USA’s S&P 500, Japan’s Nikkei 225, Britain’s FTSE 100, etc., typically include large companies from the biggest stock exchanges across the country. Some indices, such as NASDAQ-100, NYSE 100, etc., may focus only on one exchange. Similarly, there may be indices that focus only on particular sectors within a stock exchange. For example, there may be a real estate sector index that includes top real estate companies only; there may be an information technology (IT) index that includes top IT companies only, and so on.
An index is believed to represent the price movement (the share market performance) of groups of good companies within the area or sector that the index represents. Thus, indices are taken as good (and convenient) indicators of how the market as a whole has performed. Accordingly, if some investment portfolio outperforms an index, it is considered to be very good performance by that portfolio. In such a situation, it is said that the portfolio has beaten the market.
How to Beat the Market – Common Strategies to Outperform the Market
Do you think that it is possible to beat the market consistently?
Well, there are many investors (including some very well-known names) who claim that it is indeed possible to beat the market year-on-year. Some legendary investors (and various professionally managed funds) are also reputed to have successfully done this year-after-year. Let us look at some common strategies that investors use to try and beat the market. Do note that each of the following strategies is popular with some group of investors. Each of the following strategies has been used successfully by large numbers of investors and thus, each of the following strategies is a proven investment strategy.
This is a very popular strategy and is used by a lot of equity market investors. The core idea behind value investing is to purchase under-priced shares of good companies. Typically, such investors search for good companies in mature industries. Such stocks generally do not offer high growth in the short term. However, in the long term, such stocks are expected to do well and potentially outperform the market. Do note that such stocks are generally seen as low risk investments. Hence, investors looking to safeguard their capital may also choose to invest in such stocks.
Some investors seek to outperform the market by investing in high-risk, high-return stocks. Such investors may seek to invest in shares of smaller and newer companies which may, at times, give higher returns than larger and more established companies. Such investors often seek to invest in nascent sectors (new and upcoming sectors, for example sectors dealing with new technologies).
Some investors try to benefit from short term market fluctuations in order to beat the market. In the short term, prices of various stocks keep fluctuating. Active investors try to time their investment accurately (precisely) so that they buy a stock just before its price starts to increase. Later, they aim to sell off the stock just before a decline in its price. The secret to successful active investment is identifying the right time to buy and the right time to sell a stock. Do note that investors who apply this strategy may need to reallocate their investment often. Hence, they may incur relatively high transaction costs.
Investors that use this strategy try to “be contrarian”, i.e. they try to go against the market. For example, when the market is in a decline, these investors would try to buy certain stocks. The rationale behind their purchase would be that stocks of some good companies may get undervalued in the short term due to market fluctuations. But, in the long term, such stocks would be expected to gain in value and thus, yield good returns.
Investing in Funds
There are many professionally managed funds that invest in groups of stocks or in a mix of stocks and other instruments. Instead of investing in stocks directly, investors may choose to invest in such funds. These funds offer a lot of flexibility to investors. Many funds simply try to allocate their portfolio in a manner that reflects the distribution of stocks in the market index. Thus, these funds do not aim to beat the market – these funds only seek to replicate market returns (i.e. they aim to achieve the same rate of returns that the market index yields). Many other funds try to beat the market. Funds that aim to beat the market may try to use many different strategies to achieve this result.
For example, some such funds may use value investing (these funds would try to invest in good companies in established industries). Similarly, some funds would only (or chiefly) invest in high-risk, high-return stocks. Some funds would use contrarian investment strategies. Thus, a large number of funds that use diverse strategies to beat the market are available to investors. Instead of directly investing in stocks, investors may choose to invest in some of these funds.
Beating the market is often seen as the gold standard for any investment portfolio. To be able to beat the market on a consistent basis is seen as a highly creditable achievement. You have now understood how to beat the market. You have seen the different approaches that are commonly used by investors in order to beat the market. You are now ready to choose which of these methods appeals most to you. Start applying that method to build your own investment portfolio and beat the market.
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