How to beat the stock market

Why is that?

It’s because of the continuous risk that individual investors have to take. This risk could take many forms. Selecting individual stocks carries the risk of making a wrong decision. Deciding the weightages of stocks and sectors in a portfolio is another challenge. There’s also the risk of having a market-cap bias in the portfolio. The greater the tilt towards small caps, the higher the risk.

A portfolio intended to beat the market will have to take on some kind of risk, which will have to be maintained over the long term. Even if all this is done well, there is still no guarantee that the portfolio will beat the benchmark. It’s no wonder that very few people manage to do better than the index over an entire investing career.

In fact, we would go so far as to say that most investors who beat the index over the long term do so because of one or two stocks. Excluding the gains from these stocks means the overall returns from a lifetime of investing may not be much better than the benchmark.

One huge multibagger is enough to change the financial fortunes of an investor. A 100-bagger stock, if sufficient funds are committed to it, can ensure a comfortable retirement. The contribution of all the other stocks to that investor’s portfolio would be nowhere near as important as the 100-bagger.

You don’t have to take our word for it. Here’s what Benjamin Graham, the father of value investing and guru of Warren Buffett, said back in 1976.

“In 1948, we made our Geico investment and from then on, we seemed to be very brilliant people."

This one stock, Geico, more than any other, is responsible for his excellent investment performance.

He also said this…

"Ironically enough, the aggregate of profits accruing from this single investment decision far exceeded the sum of all the others realized through 20 years of wide-ranging operations in the partners' specialized fields, involving much investigation, endless pondering, and countless individual decisions.

“Are there morals to this story of value to the intelligent investor? An obvious one is that there are several different ways to make and keep money on Wall Street. Another, not so obvious, is that one lucky break, or one supremely shrewd decision - can we tell them apart? - may count for more than a lifetime of journeyman efforts."

So, there you go. One big winner is all you need to beat the market in a big way. By ‘big winner’ we mean a stock that multiplies the original investment more than 10 times, preferably 25 times or more. This is why so many investors desperately look for the next huge multibagger stock. But then why do so few investors beat the market in the long term?

Here are the reasons.

• Not finding a multibagger stock over an entire investing carrier. Yes, this is possible. Some investors just don’t find one.
• Not recognising a multibagger. This is more common. Many investors have trading portfolios. They might end up trading a multibagger stock and even make a profit. But they don’t consider it a long-term investment.
• Not holding on to the multibagger for more than a few years. These stocks need to be held for at least 15 years or more to make a big difference to your financial life. Prematurely selling a life-changing multibagger stock is a big regret of many veteran investors.

The number of traders who consistently beat the market is even lower than the number of investors who do so. At least an investor can get lucky – i.e., find a multibagger – and then just hold on to it for a long time to beat the market.

This is not possible in trading. There are no consistently lucky market traders in the world. Indeed, there are very few traders that consistently beat the market.

So, what is to be done?

The answer is simple. Don’t try to beat the market. Instead ensure that you get your fair share of market returns. Investing in a low-cost index fund is the right way to do that.

Index funds in a nutshell

An index fund is a mutual fund that is passively managed – i.e. the fund manager doesn’t actively select any stocks. It just mimics an index, usually the benchmark index like the Nifty or Sensex. To do this, its portfolio is constructed and maintained in the same proportion as the index.

And that’s it. By investing in a Nifty index fund, you will receive returns very close to the Nifty’s. This is an index fund’s purpose. It will ensure that you receive your fair share of wealth created by the Indian stock market.

Best of all, their passive nature ensures they are low-cost. In India the total expense ratio for index funds is between 0.2% and 0.5% . For active funds, the TER is between 1% and 2%.

Are index funds better than other mutual funds?

In the short term, say one year, it’s impossible to say so with any certainty. Then again, you shouldn’t really be in the stock market if your investment horizon is one year. The market rewards patience as long as you’ve chosen good stocks.

And this is where index funds shine. Over five years and 10 years, only a few actively managed mutual funds have beaten the benchmark.

Conclusion

Index funds are a good choice for long-term investors looking for solid returns without taking on excess risk.

This doesn’t mean index funds are low-risk investments. They carry just as much risk as any other stock-market investment. However, the types of risk associated with active investing, such as picking stocks, are absent in index funds.

Also, just because you like the idea of index funds, doesn’t mean you should not do your due diligence. Do your research. Check the expense ratios. Check how close an index fund’s performance is to the index itself. Check if the fund manager is deviating from the mandate of passive investing.

Happy investing!

Disclaimer: This article is for information purposes only. It is not a stock recommendation and should not be treated as such. 

This article is syndicated from Equitymaster.com