How to Outperform the Market: 5 Ways to Do It Without Too Much Risk
How to Outperform the Market Without Taking on Too Much Risk
Using money to make money in the markets is the ultimate goal of investing. The markets perform at certain levels based on economic factors, investor sentiments, and national or global events. Investors work to find ways to outperform the market, using different methods involving financial math and statistics to determine outcomes and reduce the inherent risks of investing.
Some investors consider their portfolio to have beat than the market when it returns more than the stock market annual average of 7% to 10%. Investors and speculators are always on the lookout for investments that will beat the market. Of all the methods that exist, the ones that offer low and moderate risk are the ones that continuously perform over time.
No matter what circumstance the markets are in, there is always a risk when investing. Investment prices can rise or fall depending on economic conditions, political actions, or natural disasters. Prices fluctuate with these factors because investors believe the issuers of their investments will struggle to maintain a profit if their business is affected. This belief is called investor confidence.
Confidence in the market is highly dependent on the personal thoughts of investors, which are communicated between them. These negative thoughts are contagious enough to lead to herd panic—which causes large scale sell-offs, price drops, and even market crashes.
One example of market risk is the global pandemic of 2020, which caused governments to initiate stay-at-home orders for populations to attempt to control the spread. This caused investor confidence to waiver and resulted in a market crash. The market officially became a bear market, and then began a sinusoidal climb into a rebound.
There are other examples of the stock market crashing and correcting throughout the twentieth and early twenty-first centuries. The crash of 1929 and the housing bubble burst of 2007 and subsequent crash of 2008 are two other notable crashes which turned into recessions and caused many unprepared investors to lose everything.
To mitigate the risk of the unknown, investors can take actions that are able to minimize losses, or even result in gains during market downturns, crashes, and corrections. These actions are generally low-to-moderate risk and involve some planning before any market downturns occur, except for the strategic decision to continue purchasing value investments no matter the turns the market takes.
It should be noted that while these techniques can help investors weather crashes and corrections, there are never any guarantees that there will be any returns or gains due to the inherent riskiness of investing.
Low-to-Moderate Risk Methods to Outperform the Market
Diversify Your Portfolio
One of the most accepted methods for an individual investor to outperform the market over time is with a diversified portfolio. One way an investor can diversify could be to buy eight different assets that react differently to the phases of the business cycle.
For example, when the economy heads into recession, some holdings will rise in value (typically bonds and gold), while some will decrease in value (such stocks). The opposite will occur during an economic recovery, where the stocks rise in value, and gold decreases. This will offset the risks that come with investing in each type.
Select Stocks Using the Value Investing Technique
Stockpickers claim they can beat the market by only selecting stocks that outperform. Investing icon Warren Buffett uses this strategy successfully by purchasing controlling shares of companies with higher profit margins, a clear competitive advantage, and management he respects.
Warren Buffet's most published stock-picking strategy is called value investing.
Buffett favors stocks that many investors ignore because the value that can be placed on them that is not strictly immediate or return-based. For that reason, he searches for investments in time-tested and otherwise boring companies such as Johnson & Johnson, or Kraft Foods—commonly referred to as toothpaste stocks.
Some other methods that circulate in the investing community are actively managed funds, hedge funds, day trading, and timing the market. These methods can be lucrative for some investors—generally those with large financial holdings or professional tools and training—but for most investors, they represent an amount of risk that cannot be not realistically mitigated.
Actively Managed Funds
Actively managed mutual funds justify their high fees by claiming they outperform the market. The fund managers use strategies that try to make their return on investment superior to other funds. They also employ teams of financial and market analysts, researchers, and data-crunchers to assist with finding the highest returning stocks for the fund.
The risk comes not only in chasing returns but in the fact that actively managed funds generally have a high asset turnover within the funds—which adds the risk of higher taxes in addition to the higher fees if you have any returns.
Short-term gains (gains within a 12 month period) are taxed as regular income, which is a higher tax rate than the capital gains tax. Turnover within a fund can cause short-term gains.
Hedge funds are investments in which funds are pooled together to attempt to "hedge" the risk of investing, by working to secure continuous returns. Hedge funds claim to achieve above-average returns by using assorted securities, derivatives, and other investment instruments in attempts to generate positive returns no matter how the market swings.
A derivative is an investment that bases its value on an underlying asset, like a stock or bond. Sometimes, the funds use leverage, or debt, to try and outperform the market.
Hedge funds are generally considered to have a higher risk than other funds, which is why they are limited to those with considerable financial resources.
Hedge funds in the U.S. are limited to investors who have enough income or assets to not put themselves in financial danger. Regulations state that eligible investors must be an accredited or institutional investor—which for individuals means having at least $200,000 a year in annual income or assets that are valued over $1 million.
Day traders also hope to outperform the market. They use formulas, some forms of financial analysis, and named attributes of charts—such as a "cup and handle" or the "inverse head and shoulders"—to buy and sell a stock, options, or a derivative during the day.
They study news, events, and price trends to help them buy low and sell high throughout the day before the market closes. However, studies show most day traders don't do too well. In one study, it was shown that 97% of day traders lost money—only 3% of traders profit on a regular basis, most of which were professional high-frequency traders.
With a stock option, the trader doesn't have to put down 100% of the value of the stock to buy it. Instead, the trader can get an option to buy it at an agreed-upon price by a certain date. Often, they only have to pay between 2% and 10% of the contract into a margin account.
Margin accounts are accounts in which brokers dictate a minimum amount of capital to be maintained, no matter the market circumstance. Day traders commonly lose money on trades and lose value on their margin account. They then need to put more money into the margin account, costing them more capital.
If the value of the underlying asset rises, the trader just waits until the contract expires. In a perfect situation, they buy the stock at a low price, immediately sell it at a higher price, and pocket the difference. However, if the assets price drops, traders must add funds to keep their option(s) open. If the price doesn't rise by the time the contract expires, they have lost the entire fee plus the money to replenish the margin account—if they dipped below the margin set by their broker.
Wouldn't it be better to put all your money in certain investments during a bear market, then switch to bull market performers when the bull market begins? This is a technique that many investors try to use if they do not have the patience to wait out the ups and downs of the market.
This is known as trying to time the market. Theoretically, it could work—if you were able to calculate and forecast the market fluctuations and reversals. The ability to forecast and time the market is the ultimate goal for investors—they have been trying to figure out ways to do so since investing originated.
The Best Way to Safely Outperform the Market
Of the many options an investor has to make money, the ones that work to outperform the market are to diversify your portfolio and use proven techniques such as value investing—each of which takes time to build wealth. Key factors needed in these methods include patience, and the ability to resist panic selling when the market takes a downward turn.
Warren Buffett. " Letter to Shareholders, 2019," Page 4. Accessed May 18, 2020.
Warren Buffet. "Shareholder Letters, 2008," Page 15. Accessed May 18, 2020.
Investor.gov. "Hedge Funds." Accessed May 8, 2020.
Investor.gov. "Updated Investor Bulletin: Accredited Investors." Accessed May 8, 2020.
Fernando Chague, et. al. "Day Trading For a Living?" Accessed May 7, 2020.