There Are Two Ways To Beat The Market
Written by David Fabian, July 29th, 2017
Active investors are continually looking for innovative ways to beat the market. They want to believe that some perfect combination of fundamental or technical indicators will lead to the holy grail of outperformance (otherwise known as alpha).
In the broadest sense, there are two ways to beat the market: on the upside or on the downside. You either take more risk or less than the benchmark.
This is where you must begin your journey and set your expectations if you are ever going to successfully compound your wealth over the long-term. We can sit here all day and debate security selection, asset allocation, risk management, or other strategic factors. They don’t mean anything if you don’t understand where you are starting from and where you are going.
Beating the market on the upside is what most aggressive investors strive for. It’s also the most rewarding when some combination of luck and skill coalesces in your favor. You see your account growing in leaps and bounds, which leads to greater confidence in your own abilities and further risk-seeking behavior.
Maybe you bought all the big momentum stocks before they became truly popular or ran much further than anyone thought possible. Maybe you got in on Bitcoin when it was trading for a few bucks a token. Maybe you use double or triple leverage ETFs to magnify your gains. Maybe you are shorting volatility with every penny of your retirement savings.
Whatever the case may be. You are a rock star when stocks are relentlessly grinding higher. When volatility is low. When credit is abundant. You tell tales to your buddies on the golf course or over the water cooler about how much money you are making and how easy it is.
The downside of course is that you are far over-leveraged and emotionally unprepared for a contraction when the peak finally comes. Confidence in strategies that have worked for the last couple of years turn into doubt, then denial, then regret, then capitulation.
Those same dynamics come into play over every full cycle in the market and take a long time for you to shake off when the market does turn. It takes you months or years before you are finally able to muster the confidence to start the process all over again.
Think about it this way: when it’s good, it’s GOOD and when it’s bad, it’s BAD. That’s the life of a risk-seeker.
Beating the market on the downside is a completely different story. It’s much easier and why most investment paradigms are designed with multi-asset diversification in mind. You simply take less risk than the benchmark by owning non-correlated assets or by sizing your portfolio with more conservative holdings.
I don’t know if it’s just my inherent risk-averse nature, but I have always fallen into this camp. I would much rather feel the safety of knowing I have less to lose than the temporary euphoria and cognitive bias that I’m somehow smarter than the market.
Running conservative portfolios and always feeling like I am missing out on some amount upside isn’t easy. It takes a high degree of discipline to stick with a strategy I know will serve me well in every market environment. Let’s face it, the market is going up 60-80% of the time. It’s easy for doubt to creep in that I should be taking more risk when everything looks easy.
The true benefits are felt during the down years. The ones where the market is negative and your performance is flat or even positive on the year. The ones where everyone is fleeing in fear and you are feeling vindicated from your behavioral choices.
A more conservative risk profile allows you to think clearer when everyone else is losing their minds.
The Screw Up
I liken the above two examples to the fable of the tortoise and the hare. One is high paced and flashy, while the other is slow and steady. They more than likely arrive at the finish line around the same time and with the same net returns. The journey has just been far different.
The real screw up is when you try to be both. You are constantly switching your strategy based on the prevailing market in a failed attempt to be an all-knowing strategist. This likely means that you are chasing the tail end of every cycle based on historical performance rather than any sensible or disciplined strategy.
It’s a fail-safe way of ensuring you don’t make any progress and are constantly riding the waves of greed and fear that are the greatest constant in the markets.
The Bottom Line
Great investors know the strengths and weaknesses of their own strategy. They are also self-aware of their own emotional and behavioral triggers. This leads to strong identification with a philosophy they can implement with confidence through thick and thin.
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