How to Beat the Stock Market in Three Steps
Many people have a "fail-safe" system for beating the stock market, and they are not shy about sharing their strategy with you. Some try to get you to pay them to learn their method. You're right to be skeptical about most of these ideas.
But there is a way to beat the market in three relatively easy steps, and the biggest requirement for following them isn't a terrific amount of market savvy; it's patience.
Beat the Market by Never Selling
It's impossible to know whether the price of oil will drop over the next six months or if next month's jobs report will be a dud. The truth is, the world is too complex to know with any degree of certainty which direction oil, the labor market, or stocks will go in the short run. Over any three-year period, anything can and will happen in the stock market.
The preventative solution for losing returns by selling is to never sell. By investing in indexes, you can stay fully invested in the market until you reach your financial goals, no matter what the market does.
However, when you look at the return of stocks over the long run, it becomes clear that the only sure thing about the market is that stock prices tend to go up (and beat inflation) over time.
All of the plunges on a 50-year stock chart tend to smooth out. And think of some of the reasons people have sold off stocks over the years: debt crises, currency devaluations, the inevitable bursting of bubbles in various stock sectors. They all seemed catastrophic at the time, but after a while, they faded into footnotes.
Use Indexing to Your Advantage
The best way to take advantage of the markets' long-term rewards is by buying stock index funds, particularly those traded on exchanges. These investments are passively managed, low-fee funds that aim to match the market's returns.
The diversification of an index fund provides added security for beginning investors who may be tempted to sell during downturns and disregard the first rule.
Once you're comfortable with indexing, take advantage of the remarkable upside of retail stocks by allocating a small portion of your nest egg to a retail sector exchange-traded fund (ETF).
A retail sector ETF acts as an index of retailer stocks and can help you outpace the market as a whole.
The upside can be demonstrated by taking a look at the SPDR S&P Retail ETF, which seeks to match the return of the S&P Retail Select Industry Index. It outperformed the SPDR S&P 500 ETF, which mimics the S&P 500 Index as a whole, for much of the 10 year period that ended in July 2019. (The broader ETF surpassed the retail ETF in the first quarter of 2019.)
This simple, one-two indexing punch is an excellent plan for many investors. If you are sure you have the temperament to hold individual retail stocks during sell-offs, then buying a few can be smart. However, most investors will find sticking to the first step easier if their portfolio has the safety of diversified index funds.
Buy on the Dips to Beat the Market
Trying to time the market is almost always a bad idea. That said, as long as you aren't looking to time your way "out of the market" (remember, don't sell), there's nothing wrong with adding to your positions when the market pulls back sharply. If you never sell, stick to index funds, and buy more when the market declines, you should crush the market's returns.
A good strategy is to dollar cost average (purchase no matter what) with index funds every month, rain or shine. Then, when the market pulls back 10% in a month, your regular contribution will buy you more shares at a lower price—and decrease the average cost you paid for the investment.
Buying index ETF shares when the market is down is similar to purchasing an item on sale.
Recognize when you're buying on declines—and appreciate the benefit you're getting from dollar-cost averaging—but try not to obsess over what your funds are doing until you near retirement.
The Importance of Being Patient
Your instincts are likely to make this relatively simple plan much harder. Unfortunately, we've been hardwired to follow crowds through years of evolution, listen to perceived experts, and be risk-averse. While these traits can serve us well in some of life's pursuits, they can make successful retirement planning hard.
In theory, holding stocks for the long haul makes sense. But when the rubber hits the road, we often want to get rich quick(er) and panic every time the market dips.
This strategy will test your patience and temperament more than your market acumen. Buying S&P 500 and retail index funds, adding to your positions during dips, and never selling should work for you if you have the patience for it.
The Balance does not provide tax, investment, or financial services and advice. The information is being presented without consideration of the investment objectives, risk tolerance, or financial circumstances of any specific investor and might not be suitable for all investors. Past performance is not indicative of future results. Investing involves risk including the possible loss of principal.