Most investors want to know how to beat the market. They are always looking for the next hot stock or tip that is going to boost their returns into the stratosphere. The truth is, there are only two proven ways to beat the stock market:
- Trade on superior information
Of these, chances are you have a better shot at being lucky than you do of obtaining superior information. Think about how you usually come across news about companies. For most people it is through the news. Odds are that if you know the information, everyone else does as well. This is the basic definition of the efficient market hypothesis. It states that the market is always pricing in new information. So, by the time you get the information, the stock market has already factored this information into account.
As for luck, Eugene Fama and Kenneth French completed a study, Luck versus Skill in the Cross Section of Mutual Fund Returns. In the study they found that US equity fund managers from 1984 through 2006 most actively-managed fund performed worse than the market when taking into account fees.
But what about the handful of managers that did beat the market? Fama and French created simulated portfolios which showed that the majority of managers that beat the market did so based on luck and not on skill.
What does this tell us? It tells us that the odds of you being in possession of superior information is unlikely and that those that beat the market are simply lucky. If you’ve ever been to Vegas, you know that at some point, your luck is going to run out.
Your best solution is to invest in a well-diversified portfolio of low cost funds and ETFs that track the market. There is no point in paying more for actively managed funds when the chances are that extra cost doesn’t pay off through increased returns.