5 Ways to Outperform the Market

Definition: Outperform the market means doing better than the market average. It’s also known as beat the market. It happens when your investment portfolio does better than the stock market overall. In other words, its average annual return is greater than the 7-10% annual average the stock market has done over time.

Actively managed mutual funds justify their fees by claiming they outperform the market. For example, an emerging markets fund outperforms the market when it has a higher return than the MSCI index .

Stockpickers claim they can outperform the market by only selecting stocks that outperform as well. Warren Buffett has used this strategy successfully. He buys controlling shares of companies with high profit margins, a clear competitive advantage. and leaders he respected. He bought the stocks of companies that had been overlooked, either because they were in boring industries (like insurance) or were otherwise out of favor. This is known as value investing.

Hedge funds claim they can achieve above-average returns by using derivatives. Hedge funds are privately owned companies that pool their investors’ money, promising huge returns. A derivative is an investment that bases its value on an underlying asset, like a stock or bond. It uses leverage to outperform the market.

For example, with a stock option, the trader doesn’t have to put down 100% of the value of the stock to buy it. Instead, he can get an option to buy it at an agreed upon price by a certain date. Often, he only has to pay 2-10% of the contract into a margin account. If the value of the underlying asset rises, he just waits until the contract expires and buys the stock at the low price, immediately sells it for the higher price, and pockets the rest.

However, leverage works the other way, too. If the asset price drops, he must add funds to keep his option open. If the price doesn’t rise by the time the contract expires, he’s lost the entire fee.

Do hedge funds outperform the market? Some do, but most don’t. Since 2003, hedge funds returned 17% (after fees) while a stock-equity index fund returned more than 90%. (Source The Atlantic, Don’t Invest in Hedge Funds, July 10, 2013)

Day traders also hope to outperform the market. They usually have a formula that they follow, to get in and then get out of a stock, an index, or a derivative during the day. They hope to take advantage of news events, price trends, or following a trading plan to buy low and sell high before nightfall.

How Can You Outperform the Market?

The best way for an individual investor to outperform the market over time is with a diversified portfolio. Buy eight different assets that react differently to the phases of the business cycle. That way, when the economy heads into recession, some of your holdings will rise in value (bonds, gold) to offset those that drop (stocks, oil).

Wouldn’t it be better to put all your money in bonds and gold in a bear market, and switch to stocks and oil when a bull market begins? Yes, if you knew for sure that was happening. That’s called timing the market, and it’s virtually impossible for even professional traders to do. That’s because a bear market usually starts with a market correction of a 10% decline. In a market crash, this can happen in a day. If you happen to miss it, then what do you do? Sell all your stocks, in the fear the correction turns into a bear market? Then you can be sure the market will go even higher then next day, and you’ve missed all your gains for the year.

With diversification, you can gradually shift asset classes over time. You don’t have as much at risk if you are wrong. To find out how to determine business cycle phases, and what asset classes to buy in each, see Individual Investor. Article updated July 22, 2014