Beat the Market with 5 Basic Tenets of Long-term Investing

So you want to beat the market. Despite the fact that you can effortlessly earn market return by investing in index funds, despite the constant discouragement from the financial academia telling you that it’s impossible to beat the market, and despite research showing that most professionals really do fail to beat the market, you think you can do it.

The good news is it is possible. Warren Buffett once said, “Observing correctly that the market was frequently efficient, they went on to conclude incorrectly that it was always efficient. The difference between these propositions is night and day.” And I tend to agree that, if one is willing to bring intensity to the game, it is possible to earn excess return, or alpha.

But in the end the quest for alpha is a zero-sum game. By definition, the average investor cannot earn more than the average. Each dollar you make in excess to the market is taken from other investors who are earning below average return, and how much you make is depended on the edge you have over the other investors.

I believe that regardless of what your investment strategy is, incorporating these 5 basic tenets below will give you an edge over an investor who is not, all else being equal. They should form the foundation of any winning active strategy with a long-term horizon. Without further ado…

Read Wide

Have a wide variety of interests, and get into habit of reading anything that’s remotely relevant. I am not referring to simply browsing financial websites. Of course, “reading deep” in terms of doing rigorous research on the companies/sectors/asset classes you are investing in should go without saying. But if you are only reading the same things as the rest of the investing community is reading, you are more likely to think the same things as well. “Reading wide”, or seeking information beyond the normal realm of investing, increases the opportunity for synergizing outside information into an investment thesis, and you can never tell beforehand where you will come across relevant information. Also, having interests outside of investing gives you a better chance at noticing major trends ahead of the curve. For example, if you were a computer geek back in the 80s or early 90s, you might have bought the Microsoft stock ahead of the rest of the community.

Laziness is a Virtue

I could have said “Patience is a Virtue”, but this one is a little less cliché. I want to emphasize that it is good to be lazy when it comes to actual trading (but not when it comes to doing the prep work, which you definitely should not be lazy on). One of the longest running conundrum is that the average investor does significantly worse than the market average. On the surface, this statement sounds ridiculous – it is like saying the average NBA player shoots worse than the NBA average. But the former statement is, in fact, true, and the single biggest reason is that the average investor loses out by paying too much commissions and short-term taxes from over-trading. Avoid over-trading, and not only will you beat the average investor, you will probably beat the majority of the professionally run active mutual funds.

Once again quoting Warren Buffett: “Lethargy, bordering on sloth, should remain the cornerstone of an investment style.” So go ahead, procrastinate, and refrain from trading until the real opportunities arise, which leads to…

Expect Ridiculousness

The securities marketplace is part of Extremistan, the home of Black Swans.

“Black Swans” are very extreme events that have huge consequences, and Extremistan is a place where these types of events happen a lot more often than predicted by statistical normality (the Bell Curve).

What this means is don’t buy something merely because it is attractive. History has proven over and over that Black Swans live in the financial markets, thus it pays to keep your ammo dry to prepare for them. If you ever hear yourself saying, “holy s#!+, I can’t believe this market/commodity/condo/stock just dropped so much,” first, review the fundamentals. If they are still sound, you are probably witnessing a great buying opportunity. But if an investment merely seems interesting, add it to your watchlist, and then wait for that “holy s#!+” moment. You might miss a few opportunities this way, but the excess return you earn more than compensates, and more importantly, if you wait for Black Swans, you are less likely to get hit by the wrong side of one.

The flip side is also true: if it feels about right to sell a stock at $7, wait for it to go to $10! Markets often overshoot. This also works very well with the “lazy” tenet. Time and time again events have occurred in the markets that are beyond our normal range of expectations, so err on the side of inaction until the ridiculous happens – it probably will eventually.

Keep Your Options Open

It is usually not wise to have 0% exposure or fully leveraged exposure. You should always have a handful of positions ready to be sold if the market surges, and a handful of positions in your watchlist ready to be bought (and unused capital to buy them with) if the market moves against you. But, wait for the extreme moves.

Don’t be married to a particular idea. By necessity, you should have more investments that you want to buy than investments you actually end up buying. This is because, if you are following the previous tenet properly, you are not just going to invest in something merely because it is attractive; you are sitting there waiting for an extreme event to happen so you can get in at fire sale price. It is wise to monitor a large variety of choices because you never know where a Black Swan will land. “Luck favours the prepared” – position yourself such that you can take advantage of opportunities that come up.

If a particular investment runs away from you, don’t chase it; instead, make all the potential investments on your watchlist “compete” for your limited capital. This is similar to how one can do well in the dating scene – always keep a lot of options open so that your prospects are the ones doing the chasing and proving themselves to you.

Put Your Eggs in a Basket and Watch It

Diversification is a double-edge sword. The more diversified you are, the closer you are to earning the average market return, which is a terrific way for an amateur to invest and forget, and I recommend to anybody who do not wish to spend a lot of time managing money to not put all your eggs in one basket. But diversification won’t help you win the alpha-generation game you signed up for. Again by mathematical definition, you cannot beat the market by buying the market. To add value for your portfolio or your clients’, you will need to concentrate your eggs in some kind of basket (or a small set of baskets), and watch that basket. This is the mirror image of the previous tenets: read wide and keep a lot of options open, but invest rarely, make big concentrated bets, and get to know your holdings very, very well.

Advertisements

There are no comments on this post.

Leave a Reply

Fill in your details below or click an icon to log in:

WordPress.com Logo

You are commenting using your WordPress.com account. Log Out /  Change )

Google+ photo

You are commenting using your Google+ account. Log Out /  Change )

Twitter picture

You are commenting using your Twitter account. Log Out /  Change )

Facebook photo

You are commenting using your Facebook account. Log Out /  Change )

w

Connecting to %s

%d bloggers like this: