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Can we beat the stock market?
Can an individual investor beat the market?
Before providing an answer to the above question, let us discuss basic financial theory that has ruled the financial community over decades now, Efficient Market Hypothesis (EMH). EMH is indisputably a widely recognized financial theory that states that stock markets are efficient and all the stocks are fairly valued, thus making it impossible for the investors to purchase undervalued stock or sell overvalued stocks. Accordingly, no investor can outperform the market through expert stock selection. Ironically, while many financial pundits believe that markets are efficient and EMH do hold, we have investors like Warren Buffet who has consistently outperformed the market over a half a century now. Important to note, this billionaire investor has earned a compounded return of 19.7% from 1965 to 2003, while S&P 500 index has compounded only 9.8% during the same period. So, is Warren Buffet an investor God, and all we need is to just buy shares in Berkshire Hathway and lay back easily because we know he is again going to outperform the market?
The answer is no, no one can ever beat the market consistently. Many actively managed mutual funds sell their funds using the concept, but the fact is active-value management has to be a zero sum game. In other words, passive value investors hold value-weighted portfolio of value stocks, thus if any active managers win, it has to be at the expense of other active manager loss. In other words, when we think of investors outperforming the market, only a selected group (which of course cannot be same forever) outperforms the market, while other participant loses, and even the investors who successfully outperform the market, might end up failing the next year. Hence, it is possible that an individual may for one year outperform the market, but he cannot do so consistently, and the mission to outperform the market forever is impossible. This is the reason that while few hand-picked investors such as Warren Buffet and Peter Lynch have achieved the success, many or we should most of the individuals have failed to outperform the market. In fact, many professional mutual fund managers are not able to beat the market consistently, even though they have best team of analyst and stock pickers employed with them. Below are some of the factors that are the real obstacles for any investor in outperforming the market:
i) Investment and Portfolio Management Fee:
Fees charged by brokerage houses and portfolio managers from the investors are one big obstacle for an individual to beat the market. Important to note, an actively managed portfolio manager will always charge a high performance fee in addition to management fee, and eventually even if you are able to outperform the market at the year end, net of fees and other charges, it is most likely that your net returns will be below the market returns. Similarly, even if the investors invest in S&P 500 index fund, where you own very small proportion of stocks of many companies, and by the end of the year your investment performs identical to S&P 500 index returns, net of investment fee your returns will again be lower than the market returns.
Every country has its own tax regime over taxation of investment profits, but taxes are again an obstacle for an investor beat the market. Thus, when an investor pay taxes on his investment returns, he lose a significant percentage of his return.
iii) Investor Behavior
The investment psychology of an investor is a third obstacle that prevents him from beating the market. Important to note, people enters the market with the objective to buy low and sell high. However, in reality they incline to buy the stocks when market is performing well and they sell out of fear when the market starts to drop. This non-rational behavior of the investors prevents them from beating the market and this quote by Warren Buffet make him stand out than other investors in the world:
“You shouldn’t own common stocks if a 50 per cent decrease in their value in a short period of time would cause you acute distress. “
How can an investor beat the market?
While we do postulate that no individual can consistently beat the market, the only possible way that he might be able to outperform the market in the long term (net of fees) is through trading on superior insider information or by taking the risk. Talking of the former, finding superior or insider information is very difficult and moreover, trading on insider information is illegal in every exchange of the world. Thus, this leaves us with the second option to outperform the market, the risk. As we earlier discussed the EMH, the financial theory states that markets are informationally efficient and all stocks are fairly valued, the only way an investor can beat the market is buying risky stocks. There is a direct relationship between risk-reward profiles, i.e. higher is the risk, higher can be the expected return. However, this does not guarantee that risk will be fruitful and you will be able to outperform the market.
Thus, we can conclude that for an investor to be as lucky as Warren Buffet and Peter Lynch who has earned billion dollars through stock market investment and have outperformed the market, the most rational way is to invest in a portfolio group of non-correlated stocks(with good fundamentals) on a long term basis. In that case, it ‘’might’’ be possible that an investor may be able to beat the market, but with investment fees, taxes and human emotion working against him, he is most likely to depend on luck as strong as that of Buffet and Lynch. In short, as proposed by Burton Malkiel in his top-seller book, ‘’ A Random Walk Down Wall Street", stocks will take a random and unpredictable path, and it will be impossible for the investors to beat the market until he takes an additional risk and consider long-term investment strategies. At the end, to conclude this paper, we have an interesting fact that proves that long-term investment horizon and good fundamental investment in group of stocks can actually help an investor to beat the market. Here it is:
‘’ Warren Buffett made $62.7 billion of his $63.3 billion net worth after his 50th birthday. $60 billion — nearly 95% — is from after his 60th birthday. So, think of long-term investment strategies’’
Efficient Market Hypothesis. n.d. 13 April 2015 <http://www.investopedia.com/terms/e/efficientmarkethypothesis.asp>.
Ferri, Rick. Why Smart People Fail To Beat The Market. 3 December 2012. 13 April 2015 <http://www.forbes.com/sites/rickferri/2012/03/12/why-smart-people-fail-to-beat-the-market/>.
Fontinelle, Amy. Is it possible to beat the market? n.d. 13 April 2015 <http://www.investopedia.com/ask/answers/12/beating-the-market.asp>.
Gray, Wesley. Mission Impossible: Beating the Market Forever. n.d. 13 April 2015 <http://blogs.cfainstitute.org/investor/2014/11/06/mission-impossible-beating-the-market-forever/>.
Isle, Peter. 17 Facts About Warren Buffett And His Wealth That Will Blow Your Mind. n.d. 13 April 2015 <http://www.businessinsider.in/17-Facts-About-Warren-Buffett-And-His-Wealth-That-Will-Blow-Your-Mind/99-of-Buffetts-wealth-was-earned-after-his-50th-birthday-/slideshow/40266709.cms>.
Mohan, Mahesh. 101 “Hand-picked” Warren Buffett Quotes On Investing. 15 January 2014. 13 April 2015 <http://www.minterest.org/best-warren-buffett-quotes-on-investing/>.
Random Walk Theory. n.d. 13 April 2015 <http://www.investopedia.com/terms/r/randomwalktheory.asp>.
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