Professional money managers cannot beat the markets over long periods of time.
The above statement has been proven out many times, There are a few money managers who will beat the markets for a few years or even a decade, but eventually they are swallowed up, just as the break-away riders in a bike race eventually get swallowed up by the pack. (Sorry, just thinking about the movie American Flyers, but I digress.)
Individuals can and do beat the markets over long periods of time.
The second statement is also true, yet it seems to contradict the first. If a professional money manager, who has all of the education, all of the experience, all of the fancy tools, the assistants, the research staff, and the time to devote to picking stocks and tracking the markets cannot beat the markets over long periods of time, why can an individual who works forty hours a week doing other things and whom has none of the advantages beat the markets?
A money manager gets billions of dollars to invest and is constantly under the gun to perform. If he makes 13% and the markets go up 15%, investors may pull their money out and into other funds that did as well as the market or beat it. This both encourages the money manager to aggressively target short-term gains and forces him to pull money out of stocks at just the wrong time to raise cash to pay those redeeming their shares.
In addition, because he has so much to invest, he cannot just buy the stocks he most believes in. If he were to put a billion dollars into one stock, he would move the price way up and get a bad cost basis. He would end up taking over the company. Instead, he must buy several stocks he doesn’t fully believe in just to be fully invested. He may like Coke, but need to buy Pepsi too. If he is not fully invested and the markets go up, he will make less than the markets and people will sell out.
The individual investor, on the other hand, doesn’t have such constraints. He can pick just a hand full of stocks in which to invest. He can invest without worrying about moving the share price up, and can sell out without worrying about moving the share price down. He can also hold on for years and years, waiting for the market to realize the value of the company and bid the price up accordingly.
So the strategy that allows you (but that won’t ensure that you will) to beat the market(but that won’t ensure that you will) (but that won’t ensure that you will) is the following:
1. Select the best stocks from a few different sectors. Find the stock in the restaurant industry that has the best prospects for growth. Find the internet stock that has great potential. Find the retailer that is well run and opening up new stores in new markets.
2. Buy in over a period of time, buying on dips and being patient. Understand that you will not get the perfect price most of the time, but know that you’ll get a good price by putting money in a little at a time.
3. Plan to hold the stocks for many years – a decade or more. Give the company time to grow and expand. Don’t worry about the stock price – you wouldn’t sell you home just because the price went down during a quarter, would you?
But wouldn’t you be better off just buying index funds and ETFs? Buying individual stocks, you could pick badly and lag the markets. You could also have a stock go bankrupt, or just go nowhere. Emotions could also take over and you could end up selling out at just the wrong time.
The answer is, there is no reason to not do both. Buy index funds in your IRA and 401k where you can defer taxes on distributions and dividends. Buy long-term growth stocks in your taxable account. If you do well picking stocks and have some big winners, trim back your holdings a bit and add some ETFs to your taxable account. Preserve the gains you make while still letting your winnings grow in proportion to the size of the risks you are willing to take.
You can beat the markets, over long periods of time, through stock picking, even if the professional cannot. But it takes a lot of patience, and it doesn’t hurt to hedge your bets.
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Disclaimer: This blog is not meant to give financial planning or tax advice. It gives general information on investment strategy, picking stocks, and generally managing money to build wealth. It is not a solicitation to buy or sell stocks or any security. Financial planning advice should be sought from a certified financial planner, which the author is not. Tax advice should be sought from a CPA. All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.