One of the most common questions we get is whether we can beat the market.
According to Investopedia, the phrase "beating the market" means earning an investment return that exceeds the performance of the Standard & Poor's 500 index.
Can we "beat" the S&P 500 based on this limited definition?
The answer to that question is yes! But you should understand how, because there are important tradeoffs and limitations.
Cash beats the market in downturns. It doesn't mean we should become cash investors.
Stock returns are highly unpredictable and volatile. So much so that that one-month Treasury bills, a cash equivalent, outperformed the market 31% of the time between 1928 - 2022. You can see that in the chart below. Every red bar is a year when the market underperformed one-month Treasury bills.
We have no basis to expect that cash should outperform stocks over the long run, and it hasn't, yet sometimes holding cash will "beat the market." This somewhat absurd example highlights that we need to consider long-term expected returns and risk.
Strategies with higher long-term expected returns
The Efficient Market Hypothesis states that beating the market without taking more risk is impossible. Those who believe in it might be surprised to learn that there exist strategies expected to outperform the S&P 500 when only considering returns. The idea that there is no way outperform the market average has been outdated for decades. Today, we know of multiple dimensions of risk that can increase or decrease expected returns without running afoul of the Efficient Market Hypothesis.
In a previous article, we wrote about those dimensions along which the stock universe can be sorted by their expected returns. These dimensions, or factors, include Value, Profitability, Low Volatility, Momentum, and there may be others.
Building a market-beating portfolio involves overweighting stocks in one or more dimensions with higher expected returns and underweighting stocks with lower expected returns.
For example, the diagram below shows how, according to a 2012 paper by Novy-Marx, a portfolio that concentrates on small, profitable companies has higher expected returns than the S&P 500, which invests in only large companies with varying profitability.
For illustrative purposes only. Colors represent relative returns from Table 4 in The Other Side of Value: The Gross Profitability Premium Novy-Marx (2012) and do not guarantee future performance. Actual returns may be higher or lower. The methods used in the paper represent academic concepts that may be used in portfolio construction, but are not available for direct investment.
It is possible to create a portfolio that combines multiple dimensions and concentrates on each one to create a multi-factor portfolio where the effects of each dimension are additive.
Harnessing the power of risk
The problem with attempting to "beat" the market is that it creates the conditions for chasing returns without consideration for risk. Left Coast screens clients for return chasing behavior because it is one of the most potentially damaging behaviors.
In another post, we wrote about how it is vital to consider risk in addition to returns when designing a portfolio. The dimensions mentioned above have been called "risk factors" for good reason. They can have some seriously undesirable properties for certain individuals such as exposure to economic risk, long stretches of underperformance, and other issues.
The average investor is still best served by low cost, total market funds, but most individuals are not the average investor. Some individuals are suited to value or momentum investing. Others may do better by taking the opposite direction. It depends on your personality and your situation.
How do you know which risks you can take and which to decline?
Our role at Left Coast is to get to know you and then use that understanding to build a portfolio with the risk and reward profile that's best for you. We consider all the known sources of returns and match you to them as your risk profile suggests. In many cases, we expect returns better than the S&P 500, and in other cases we expect more safety and security of principal.
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