Beating the markets returns is difficult. Why? The reasons are many, but some of them are behavioral and others are trading costs. Let’s start with the first one. To beat the market you need to have a portfolio of stocks that is different from the markets. That means that you can forget buying an index fund if your goal is to beat the market (As the index fund of course gives you the markets return)
So that means that you need a more concentrated portfolio of stocks. I don’t know any specific number but anywhere more than 50 stocks will probably give you a return that is closer to the markets return. So since you need a more consentrated portfolio (preferably 5-20 stocks) you will experience more volatility in the portefolio value. And that can hurt emotionally.
We know from research that the number one reason why the average investors underperform the market is that they buy on top and sell on the bottom. A higher volatility in your portfolio makes it easier to be affected to this behavioral error and do the exactly wrong thing at the wrong time. Apart from the need to handle higher volatility you also need to do a lot of more decisions about buying and selling stocks. This make you prone to get affected by the media, other investors, stocks tips etc.. that will increase the chances that some of the behavioral biases makes you make irrational choices that hurts your returns. One of these is frequent buying and selling stocks that will take away from your annual return in form of trading costs and taxes.
The next one I want to take about is that if you want to beat the market you need an opinion that is different from the market, and you need to be correct about it and the market need to be wrong. If the market is opinion is correct and yours is wrong you will lose money. If your opinion is the same as the markets opinion you will get the markets return. Just think about that for a second. You have to bet against what is the collective knowledge of maybe thousands of investors analysing a stocks future performance. You need have an opinion that is different from them, and you need to make a bet and you need to be right in you predictions. So whats the big deal about this?
Well, you need to be brave to be a contrarian and go against the common and popular opinion about a stock. We humans are social animals and its most comfortable to conform to the opinions of the masses. Also you need to be able to be comfortable looking like an idiot for a long time as the stock price can fall a lot after you buying it and you will still hold it until it reaches it’s intrinsic value. This can take up to many years, and in the meantime you will look stupidly wrong and the market will look correct and that you made a mistake. To handle all of this you need extreme patience, discipline, emotional intelligence, confidence, and at the same time humility.
Also when you know that for the most part the market is efficient (that means correct pricing of stocks) then you can say that you are bold when you bet against the market.
I am not saying that you should give up stock picking, and buy an index fund. Not at all, especially not in this current market conditions where US index funds are very highly priced. What I want is that you think about what it really requires and demand from you to beat the market over a long time period. Few investors manage to beat the market by a large margin over years and decades. Are you one of them?
- Do you have more knowledge about analysing stocks than the average investors?
- Are you willing and able to handle the increased volatility that can be experienced with a more concentrated portfolio?
- Are you more knowledgeable than the seller of the stock that you are buying?
- Are you able to handle to look wrong for and extended period of time, before you eventually are proven right (assuming you actually made a good bet)
- Do you have more patience, discipline, emotional intelligence, confidence and humility than the average investor?
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