How to Beat the Market

Tim Hale Smarter Investing 3rd edition

Chances are, you’ve read articles saying that it is impossible to beat the stock market–that is, to consistently earn higher returns than the stock market averages. At a recent conference for industry professionals in Dallas, the distinguished economist Dr. Horace Brock offered a deep dive into economic theory, and told the audience that there are actually multiple ways to beat the market.

The first and most obvious way is cheating. If you have inside knowledge about a stock that nobody else possess, then you can make more astute trades than everyone else. The Securities and Exchange Commission (US regulator) has managed to catch a number of these criminals. You may have heard of Ivan Boesky, or Martha Stewart’s famous phone call to her friend the founder of ImClone. Quest Communications chief Joseph Nacchio dumped more than $50 million of company stock in 2005 before his company went into decline. More recently, police are pursuing a massive insider trading case against a French doctor and FrontPoint Partners, who are accused of netting $30 million while trading on nonpublic knowledge.

Until they were caught, these “investors” (and Galleon Group hedge fund manager Raj Rajaratnam, Charles and Sam Wyly and certain Bear Stearns hedge funds) were making a lot more money in the markets than you and I ever will.

If you’re not especially good at cheating, then you can rely on the second way to beat the market: luck. Don’t laugh; there’s evidence that most of the actively managed investment funds that outperform the overall market in any given year just happen to be lucky. Their luck tends to lead to bad luck for investors, however. Investors have a tendency to assume that the fund managers who had great performance this year are brilliantly astute, move their money out of less-lucky funds, and then lose money when the managers’ luck runs out and their funds underperform by roughly what they were outperforming before. Net-net, these managers had exactly as much bad luck as good luck, but many more investors were exposed to the bad luck period than the good luck period. Ouch!

You can also win the lottery, and some people are lucky enough to do so. Their “investment” return on that lottery ticket is astronomical; nobody can deny that.

Dr. Brock offered three other ways to beat the market, all of which rest on sounder footing. By way of background, he cited very complicated research by Mordecai Kurtz at Stanford University which showed that almost 95% of the short-term market movements can be explained by two things: news and expectations. The news is pretty simple; suppose Intel beats the consensus estimate of its earnings next quarter by two pence a share. This can either send the stock price soaring or tumbling, depending on whether most investors expected the stock to miss its earnings estimate (therefore, the news is better-than-expected and the stock rises), or to beat its earnings estimate by more than two pence (bad news, the stock plunges). Bigger picture, the news might be that Greece has tumbled into default, causing a short-term plunge in stocks around the world.

But longer-term price movements depend on how the world changes more gradually, based on trends that are not obvious and seldom in the news. To take some of the more obvious examples: China abandons communism and gradually becomes the second-largest economy in the world. The Internet is born, and creates entirely new market dynamics. Europe adopts a new common currency, which sets in motion a lot of other changes for good or ill.

So how do you beat the market? If you are slightly more astute about understanding the business implications of these trends than the average person, Brock told his audience, then it is possible, over the long-term, to position your assets more advantageously. Your secret sauce is thinking and reading–or investing with very thoughtful money managers who take a long-term view of gaining returns.

You can also beat the market by not following the herd. Brock said that new mathematical models of market bubbles and busts allow for what he called “the uneven distribution of mistakes,” a world where most investors can be wrong about their expectations or evaluations, all in the same direction. Remember how people were buying and selling houses prior to 2007, moving up the property  ladder, and London and New York were betting the world that housing prices would never go down? Remember the technology mania leading up to the 2000 Tech Wreck?

You can beat the market by holding a diversified portfolio (which will keep pace with the market) and systematically rebalance your investments regardless of what fearful or euphoric cries other investors are screaming outside your window. That way, when the distribution of mistakes is nearly 100% on the side of euphoria, you will be holding fewer stocks than the average investor and participating less in the inevitable bust. And when the distribution of mistakes is on the side of fear and nobody wants to own stocks, you’re participating in the market and benefiting from the inevitable recovery.

These last two methods of beating the market are not nearly as exciting as cheating or winning the lottery. So if you want excitement, you can turn to the last way that Brock said markets can be beaten. Every active fund manager has active traders who stare at six or eight computer screens all day long, with their finger hovered over a buy or sell button. They study expectations, and then, as soon as news arrives, that instant, they make a trade that will be thousandths of a second ahead of other quick-twitch traders–and, probably, a few days ahead of the trade that you and I would eventually be tempted to make.

This quick-twitch trading arrangement doesn’t always work out exactly as planned, however, which greatly adds to the excitement. Bruno Iskil, otherwise dubbed “The London Whale,” managed to trade away more than $6.2 billion (with a “b”) of the assets of JPMorgan in 2012, while Brian Hunter’s quick reflexes on the keyboard ultimately cost hedge fund investors in Amaranth Advisors a total of $6.4 billion in 2006. Baring Brothers Bank collapsed in 1995 thanks to the fast and furious futures and options trading activities of Nick Leeson. Yasuo Hamanaka at Sumitomo Bank ($2.6 billion in losses), Jerome Kerviel at Societe Generale Bank ($6 billion), Toshihide Iguchi at Daiwa Bank ($1.1 billion) and Kweku Adoboli at UBS ($2 billion) all generated their share of excitement for the institutions that employed them.

The good news here is that it appears, based on sound theoretical evidence, that people CAN beat the market in a variety of ways. Some of them are legal, but only a few are safe. The safest methods also happen to be pretty boring–and, alas, they don’t come with guarantees.

Duncan R Glassey
Senior Partner – Wealthflow LLP

This article is distributed for educational purposes and should not be considered investment advice or an offer of any product for sale. This article contains the opinions of the author but not necessarily the Firm and does not represent a recommendation of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but is not guaranteed. Past performance is not indicative of future results and no representation is made that the stated results will be replicated. Errors and omissions excepted.