How to Beat the Stock Market in Three Steps
Lots of people—from writers and TV personalities to co-workers or your least-favorite uncle—have a "fail-safe" system for beating the stock market. You're right to be skeptical about most of these ideas.
But there really is a way to beat the market in three rather easy steps, and the biggest requirement for following them isn't a terrific amount of market savvy; it's patience.
Step 1: Never Selling
A study showed that over the 30-year period from 1983 to 2013, a significant proportion of stock gains happened on just trading 10 days. Investors who were out of the market during those 10 days saw their return for the period drop 2.6 percentage points.
The preventative solution for that is to never sell. That's right. Stay fully invested in the market until retirement (or whatever your long-term financial goal is).
You can't possibly know for sure 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, say, three-year period, anything can and will happen in the stock market.
However, when you look at the return of stocks over the long run, it becomes clear that about the only thing that is certain is that stocks tend to go up (and beat inflation) over time.
Over the course of decades, 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.
Step 2: Indexing Two Ways
The best way to take advantage of the markets' long-term rewards is by buying stock index funds, particularly those that are traded on exchanges. These investments are passively managed, low-fee funds that aim to simply 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 step 1.
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). This kind of ETF acts as an index of retailer stocks and can help you outpace the market as a whole. For instance, the SPDR S&P Retail ETF, which seeks to match the return of the S&P Retail Select Industry Index, outperformed the SPDR S&P 500 ETF, which mimics the S&P 500 Index as a whole, for much of the 10 years ended in July 2019. (The broader ETF surpassed the retail ETF in the first quarter of 2019.)
This simple, one-two indexing punch is a great 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 step 1 easier if their portfolio has the safety of diversified index funds.
Step 3: Buying on Dips
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 rule 1), there's nothing wrong with adding to your positions when the market pulls back sharply. If you never sell, stick to index funds, and simply buy more when the market declines, you should crush the market's returns.
A good strategy is to dollar cost average with index funds every month, rain or shine. Then, when the market pulls back 10 percent in a month, your regular contribution will buy you more shares—at a lower price—and will decrease the average cost you paid for the investment.
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 brain is likely to make this relatively simple plan much harder. Unfortunately, through years of evolution, we've been hardwired to follow crowds, 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 (or, at least, quicker) and panic every time the market dips.
So 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 let 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.