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What does beating the market mean? Is it possible?
Whether one can consistently beat the market - and what it takes
The phrase beating the market can mean different things for different people. The intuitive definition is to earn returns on a portfolio level that consistently beats the market index. However, more people allocate their equity investments in funds managed actively than passively - so it makes sense to see how your returns stack up against that of professional investors (simply put, those who invest money on behalf of others), or at-least try to understand how an individual investor has a fighting chance against institutions in the chase for every possible rupee gain.
It's easy to achieve average market performance, one simply needs to buy the market through a low cost index or exchange trading fund - and there's nothing wrong with aiming to get what is known as market returns; between February 2000 to 2020, over a 20 year period, Nifty Total Return Index returned a compounded annualized growth rate of 14.3% per year, comfortably beating inflation.
If efficient market hypothesis is to be believed, stock prices reflect consensus view of all publicly available information that can have a material impact on the price action of the stock. However, that doesn't render the exercise of finding mismatches between price and intrinsic value of a stock ineffectual. Instead, it involves finding instances where the consensus view of the market is itself inaccurate, thus creating an opportunity to make money from the divergence.
So, if an analytical mind is willing to invest time and effort in pursuit of such mismatches, earning profits higher than the market returns is possible, and can be a great tool to create wealth for goals.
There are several logical, financial and regulatory obstructions that a professional investor has to face, which makes the prospects of individual investors beating them higher. Some are,
The account size of professional investors is such that any meaningful investment in a midcap or smallcap stock has an impact on its price. And so, they're constrained with a limited universe of companies to pick from.
Professional investors are bound by the mandate of the fund they manage, and so any investment that falls outside of this mandate is out of the question, further constraining the universe of companies to invest in.
Like an individual investors, the performance of a professional investor is compared to market returns. However, unlike an individual investor, a professional investor can't pragmatically afford to underperform the market for a long duration at the risk of losing their clients. To a professional investor, this is known as benchmark risk, and the only way to keep up for them is to imitate an index once a reasonable alpha is generated. Once this happens, the professional investor generally tends to stop caring about additional returns, and rather focuses on averting losses that could cost them their jobs.
Most professional investors lean towards having a diversified portfolio as a consequence of avoiding these risks, and thus outperforming the market with such diversification is relatively improbable compared to a curated portfolio maintained by an individual investor.
It is worth noting that the exercise of comparing an individual investor's returns against that of the market, and that of professional investors is relative in nature. However, picking stocks should encompass more than that. Critics would be correct to note that majority of individual investors beating the market luck out on taking incremental risks that they don't necessarily know or acknowledge. As Seth Klerman notes in his annotation in Howard Marks' The Most Important Thing —
"Beating the market matters, but limiting risk matters just as much. Ultimately, investors have to ask themselves whether they are interested in relative or absolute returns. Losing 45 percent while the market drops 50 percent qualifies as market outperformance, but what a pyrrhic victory this would be for most of us."
Another upside to the exercise of stock picking is that if it is done correctly, the comprehension / understanding of risks associated with the equity you hold is higher than when investing in a fund — active or passive. The reasons are simple:
The investor is more likely to be doing their own due diligence for the underlying stocks in their direct stock portfolio.
Generally, a retail investor's stock portfolio is more concentrated than an equity fund (let alone more than one in aggregate, which seems to be the norm), so it takes less time and effort to keep track of stocks in a direct stock portfolio than stocks in an equity fund.
Also, as Seth explains, an investor has to think in terms of both absolute, and relative returns - beating the market matters, but absolute returns are equally important; the inverse of this is also true - one may be able to reach their self-defined goals in terms of returns, but under perform the market in a bull run.
Apart from benchmarking against the market, or self-defined goals, some investors often pick up direct stock picking for much simpler reasons - enjoying the process behind evaluating a business, and acting upon opportunities provided by the market. That is, there's a certain pleasure in doing it yourself.
Establishing the possibility of beating the market is futile if one doesn't acknowledge what it takes to do it consistently — a brutal cocktail of time, effort, discipline, conviction, contrarianism, and an investment philosophy to invest the time, effort, discipline, and conviction in.
An investment philosophy can be thought of as a construct of mental models upon which the investor builds his portfolio upon. If the universe of stocks under the investor's circle of competence is chaos - an unexplored territory of potential, the investor mines out order from this chaos in the form of a portfolio, using mental models as forklifts. The lack of having an investment philosophy generally results in owning stocks that are not a perfect fit for the portfolio. As Chuck Palahniuk writes in his book,
'If you don't know what you want, you end up with a lot you don't.'
So, mental models help investors validate their strategy by providing a confined framework, and an investment philosophy is a set of mental models that the investor follows. Luckily, mental models in stock picking have been figured out to a large extent (such as momentum, growth, low multiples and value investing), one simply needs to recognize, study, and implement them.
For all intents and purposes, every investor (professional and individual) competes in pursuit of profits in any asset working with the same information available in the public forum. The consensus on the impact of this information is what establishes the stock price in the short run, and so if your view aligns with that of the majority, it makes sense that you'll largely make market returns - every investor can't beat the market as together they are the market. To get extraordinary returns, you need to have an extraordinary perspective. This is what Howard Marks calls second level thinking, Ben Graham calls trace of wisdom, and Warren Buffett & Charlie Munger call having an edge.
This is not to say the consensus view of information is always wrong, in all likeliness millions of other investors may be smarter and more knowledgeable than you. The idea is to find instances where the individual investor can use contrarian insight that the market isn't reflecting, and it has to be accurate, or at-least more correct than the consensus view.
To quote Howard Marks' The Most Important Thing,
Only if your behaviour is unconventional is your performance likely to be unconventional, and only if your judgments are superior is your performance likely to be above average. For your performance to diverge from the norm, your expectations— and thus your portfolio—have to diverge from the norm, and you have to be more right than the consensus. Different and better: that’s a pretty good description of second-level thinking.
Marks also proceeds to provide a framework, a set of questions that an investor must ask when working with contrarian thinking,
What is the range of likely future outcomes?
Which outcome do I think will occur?
What’s the probability I’m right?
What does the consensus think?
How does my expectation differ from the consensus?
How does the current price for the asset comport with the consensus view of the future, and with mine?
Is the consensus psychology that’s incorporated in the price too bullish or bearish?
What will happen to the asset’s price if the consensus turns out to be right, and what if I’m right?
To sum it up, holding consensus view on any material information comes naturally to us — specially if an investor relies on financial news channels or social media to acquire information; but that's not how above average returns can be achieved, by definition consensus views largely yields market return. The ability to accurately spot market inefficiencies requires an edge.
Taking the time and effort to read annual reports, brokerage reports, primers, conference call transcripts, and various other filings are all part of what an investors signs up for while performing due diligence for a company. Skim, and you may miss what disproves your investment thesis, which is perhaps one of the major reasons for higher churn rates in an individual investor's portfolio.
When asked on how to make smart investments, Warren Buffett said,
“Read 500 pages like this every week. That’s how knowledge builds up, like compound interest.”
To beat the market, you need to bring what's needed to be a succesful investor, and that means sacrificing a lot of time and effort that could have been used elsewhere, like your day job. At some point, an investor needs to decide whether the cost of time and effort exceeds the benefit of outperformance in his/her stock picking journey.
Having an accurate non-consensus view will only get you as far as your conviction on the investment thesis goes. Remember, the market can stay irrational for long durations of time. As Sanjay Bakshi notes in his appearance in an episode of the We Study Billionaires podcast, unlike many other professions, an investor rarely receives an immediate feedback on his operations. Sometimes it takes years for the market to catch up to intrinsic value of an asset, and so it is hard to separate luck from genuine success — so hold on to the underlying process rather than focusing on the outcome. A good handle on your conviction helps you to hang in until other investors catch up on the market's inefficiencies. On this subject, Joel Greenblatt annotates on The Most Important Thing,
I always tell my students, “If you do a good job valuing a stock, I guarantee that the market will agree with you.” I just don’t tell them when. It could be weeks or years.
Another thing to note is an investor should never rely on borrowed conviction, primarily because it's never enough to hold on to. If you don't do your own research, and rather rely on someone else's, the conviction tends to be weak, and so emotions act up, and exit plans are broken before the thesis fully appreciates. The other reason is that you have to rely on the goodwill of the researcher, as they may not warn you if something disproves their thesis.
As Howard Marks notes in The Most Important Thing, investing is more art than science — in the sense that past results can't be relied upon with confidence, the cause and effect relationships can't be depended upon. And so, investing can't be routinized. An investor must be able to adapt to changes in the market dynamics to consistently outperform the market.
To sum it up, an individual investor needs to invest time and effort, have a capability to think on a higher level than the consensus view, adapt to changes in market dynamics, and have the capacity for patience and conviction to consistently beat the market.