Myth Busting No. 2 – They Say You Can’t Beat the Market… But You Can
There’s no shortage of common misperceptions that lead retail investors to doubt their own capabilities.
On Wednesday, we discussed the common myth that cash is safer than stocks.
We know that’s baloney.
Want another myth? It’s the argument that you can’t beat the market.
Why does this myth exist? Why are so many people convinced they can’t outperform the S&P 500, the popular benchmark for performance comparisons?
And what can you do to beat the market more years than not?
I’ll break this myth in half and show you a few tricks to increase your odds of success in beating the market in 2021 and beyond.
Why Does This Myth Exist?
It’s not easy to beat the market.
Let’s get that out of the way.
But it’s not impossible. Setting expectations is very important as an investor.
There are many famous money managers who can’t beat the market on a regular basis. Perhaps the most famous, Warren Buffett, trailed the performance of the S&P 500 in 2019 and 2020 combined by 37%.
Meanwhile, even the streakiest performers like former Legg Mason value specialist Bill Miller have off years. Although Miller beat the S&P 500 every year from 1991 to 2005, his fund lost more than 66% of its value in 2008.
Miller has since recovered, but it is important to remember that you’re very unlikely to top the market every year.
But can you beat the market in 2021 or 2022? Absolutely.
This myth exists for a variety of reasons that are largely outside of your control. Fund managers who typically don’t even beat their own benchmarks will still use this myth as a marketing message.
It’s common to tell investors that they can’t beat the market themselves and that they need professional help.
Yet, the messaging is flawed. Managers tend to make the same errors most investors do.
In 2012, the National Bureau of Economic Research issued a report stating that advisors are just as likely as their clients to chase performance instead of taking a disciplined approach through asset allocation.
The authors stated that “the market for financial advice does not serve to debias clients, but actually exaggerates biases that are in the adviser’s financial interest while leaning against those that do not generate fees.”
Yes. Even the professionals can fall into the same mental traps as mom-and-pop investors.
The Problem with Fees and Taxes
Two of the three biggest barriers to beating the market can accelerate if you’re leaving your money outside of your control.
The first: Investor fees.
Hedge funds, for example, have long charged a 2% management fee and a 20% performance fee. So, right off the bat, you’re losing 2% of your money and hoping that the manager outperforms the market so dramatically that he or she can cover those fees on top of the 20% fee based on your gains.
That sounds extremely risky for anyone trying to beat the market. And if your money manager takes your money and puts it into index funds or other assets that have management fees, those costs will also erode any potential gains.
Here’s another place where beating the market is impossible. Let’s say that you or a money manager put money into an exchange-traded fund like the SPDR S&P 500 Trust ETF (SPY).
This ETF attempts to replicate the performance of the S&P 500. But there’s a catch. There is a gross expense ratio of 0.095%. That tiny fee signals that you can’t beat the benchmark outright because the adjusted return minus the fee will be less than the S&P 500’s performance.
In addition, it doesn’t include any commissions or broker fees.
There’s another factor out of your control as well: Taxes. Remember, when you sell any stocks that you’ve held for under 12 months, your gains will be taxed as ordinary income. You don’t lock long-term capital gains until after holding an asset for at least one year.
There’s a third barrier that we’ve discussed in several recent installments of TradeSmith Daily, which is investor psychology and cognitive bias.
Overcoming Bias to Beat the Market
Yes, you can beat the market. Doing so requires patience, diligent research, and an ability to check your emotions and bias.
As I’ve said before, the individual investor is typically his or her greatest enemy when it comes to the pursuit of gains. As I explained in our series on cognitive bias, investors tend to be more averse to short-term losses, they chase winners, and they try over and over again to time the market.
What’s worse? Investors will tend to gravitate to certain stocks because these companies generate big headlines. Yet, they’ll miss out on an asset like real estate investment trusts (REITs), which have historically provided market-beating total returns due to an appreciation in real estate assets and strong dividends.
According to the National Association of REITs (NAREIT) and Slickcharts, the FTSE Nareit All Equity Reit (Total Annual Return) registered average gains of 13.3% from 2000 to 2020. That figure for the S&P 500 was 7.7%.
Real estate isn’t that exciting. Buildings are boring. But the returns speak for themselves. So, while you might be tempted to buy and sell stocks that are highly touted by Wall Street analysts or television personalities, opportunities exist that don’t generate as much coverage.
It’s not just real estate that can produce market-beating returns. Some of the other strategies that we’ll be discussing in the future have beaten the market more years than not. These include the use of undervalued closed-end funds with strong dividends, deep value investing, small-cap value, and more.
I’ll explain these strategies and assets as we continue to break the common myths of the markets.
Using these types of active strategies can help you reach your goals faster and limit your risks.
I’ll be talking about another way to improve your odds of success on Monday. Have a wonderful Memorial Day weekend.