Beating the stock market is the holy grail for many investors, and it's not hard.
You can try to beat the market through luck, just as you can win the Powerball lottery by mere luck. Better still, you can beat the market through knowledge and discipline. I'll show you how.
The average investor is actually very unlikely to beat the market. Many people let their emotions (mainly greed, fear and impatience) stop them from doing the right things. Others fall prey to Wall Street's sales pitches. Still others, unfortunately, just don't know what they're doing.
Most experts regard the Standard & Poor’s 500 Index as “the market.” Some studies indicate that only one-in-20 investors beat that bogey over long periods — including professionals.
The evidence: The most recent DALBAR study found that in the 20 calendar years ending in December 2011, the S&P 500 had a 7.8% compound rate of return. In that same period, the average investor in U.S. equity mutual funds earned just 3.5%.
However, if you have reasonable expectations and you don't demand immediate results, beating the market is a piece of cake!
10 ways to beat the market
One: The most obvious way to beat the index is with leverage. Sure, investing with borrowed money is risky, but that's true of any investment. If you invest $10,000 of your own money and add 10% margin, $11,000 goes to work for you. After the cost of borrowing, that can probably add 0.2 to 0.4 percentage points to your annual long-term return.
But don’t overdo it. Don’t use more than 25% leverage. That could add more than 1% to your long-term return without too much risk of a margin call.
Two: Want more? Skip the S&P 500 Index and substitute a large-cap value fund such as the Vanguard Value Index. Over the long term, that will (based on history) boost your expected return by about 1%.
Three: Another way to seek that extra one percentage point is to invest in a REIT fund like the Vanguard REIT Index Fund. That will give you a dividend-based return in an asset class that's not highly correlated with the overall stock market.
Four: If you want extra long-term horsepower to leave the S&P 500 in the dust, put your money in a fund such as Vanguard's Small Cap Index Fund. Over the long haul, small-cap stocks have beaten the market about half the time. This is an especially good choice for younger investors.
Five: If you want to try for still more, substitute small-cap value stocks through a fund such as the Vanguard Small-Cap Value Fund. Over the past 80 years, this asset class has beaten the S&P 500 Index by three percentage points annually.
Six: Go beyond the borders of the United States. International large-cap value stocks, available in the Vanguard International Value Fund, have about the same historical advantage as U.S. large-cap value stocks.
Seven: International small-cap value stocks, like their U.S. counterparts, have historically beaten the S&P 500 Index by about three percentage points in the long run. The WisdomTree International Small Cap Dividend ETF gives easy access to this asset class.
Eight: Most experts expect emerging market stocks to beat the S&P 500 Index. This doesn’t happen every year or even every decade, of course. But over the past 10 years, emerging markets stocks have outperformed the S&P by more than 10 percentage points a year. A long-term advantage of 2% to 3% isn’t unreasonable.
Nine: Do what I do with the equity part of my own portfolio: Invest in the S&P 500 Index and each of the other asset classes mentioned here. The academic research shows — and long-term data confirms — that this combination beats the S&P 500 by about 2% a year without any added volatility.
More gain without more pain — a combination I find very appealing.
Ten: Whatever approach you use, carry it out with low-cost funds, not individual stocks. I have been talking to investors for more than 50 years, and most of them believed they could pick stocks that beat the market. Yet I’ve never met even one who could outline a stock-picking strategy that reliably beats the market.
Maybe you will be the first to do that. But remember: A recent national lottery that produced two winners also produced 175 million losers — and many times that if you count all the drawings in which every player was a loser.
You can do much better than that, and now you know how.