Trying to Beat the Market is Not for Amateurs

Investing and Markets

There is a whole industry out there that seeks to beat market returns. This is not a task for amateurs, although a lot of amateurs don’t know they are amateurs.

We continue to marvel at how many who think that they have what it takes to beat the market fail at this miserably year after year and still manage to pretend that they know what they are doing.

Another year is now upon us, and we get to look back to see how we and others have done in 2020, not the easiest of years to invest in to be sure but still a pretty good one. The S&P 500, the benchmark that all these people chase, put in a nice 18% gain. The Nasdaq 100, always a favorite of ours since it shames the S&P 500 over time, shamed it once again with its 47% gain.

The fact that the great majority of people prefer the S&P 500 year after year shows just how bar the low is with investing, as we struggle mightily to figure out why anyone would prefer the S&P 500.

Perhaps its because investors ask so few questions that this many of them simply have not wondered yet whether they should go with the Nasdaq instead of the S&P 500. Perhaps this functions a lot like the other propaganda that is out there, we don’t think, we just obey without thought. There may not be another explanation.

Beneath the ignorance, many investors have a general feeling that the Nasdaq might perform better, although they typically have no idea of the difference because they don’t even feel the need to check. They are told that they are not supposed to think about these things, so they just don’t.

Imagine putting your future on the line with your investments but having a threshold of diligence so low that you would invest in a major index, where you are happy to put all of your stock eggs in this one basket, but not even bother to look at what other baskets you could put them in.

If you’re not going to bother comparing returns, you aren’t going to be comparing risk either, and you probably don’t even know where to start as far as comparing risk goes. There is a science behind this, where we use statistics to compare the risk of investments, and although the science isn’t perfect, it sure beats choosing to be ignorant.

It turns out that the science tells us that the S&P 500 and the Nasdaq have a similar risk profile, with the difference between them on the risk side being virtually meaningless. Why would anyone choose something with a similar risk but a much lower return? That is a big mystery, and the only plausible answer is that investors have been brainwashed to the extent that they don’t think at all about what they are doing, instead choosing to do what they are told, to mindlessly follow the crowd.

That wouldn’t be such a bad thing if the people who pulled their puppet strings knew what they were doing, providing sound advice, even providing advice that wasn’t just stupid, but sadly that’s not the case. Standard and Poor’s is a completely apt name for this index, choosing the standard without thought and remaining poor, or at least a lot poorer than you would be if not for falling for this mindless ruse.

Making standard investments and remaining poorer doesn’t satisfy everyone though, and many seek to beat these standardly mundane results by seeking to choose their own baskets of stocks to seek to better this standard. The standard they want to beat is the S&P 500, and this should be a very easy task actually, if you know what you are doing that is.

The problem is, so few of us do, and the rest is lost in their own delusions which causes them to fail to even beat this mediocre index year after year. Some give up, with the attitude that if you can’t beat ‘em, join ‘em, but many carry on failing, with a tolerance for failure that may even seem limitless.

We write quite often on this topic, in complete amazement, and the problem is that so few are amazed with this investing butchery that there are lots of people out there to try to wake up. It’s also that time of year again, when everyone puts together their top picks for the coming year, and while we’ll have some for you this year as well, the important thing isn’t the picks but to understand the why behind all of this.

We like to keep this as simple as possible for our readers, and will continue with that theme. The only tactic we used last year was to take the top 10 performers in the market for the year before and select the 5 that also made an all-time high to conclude 2019.

There are two separate things that these stocks have working for them which also happen to be the two most important things to look for in a stock, and we can even say that they are the only two things worth looking at, how a stock has performed lately and how it is performing at the decision point, in this case the close of the year.

There was more to this simple formula than meets the eye though, and what we were really looking to show is how people do not have to be afraid of strong performers because strength breeds strength and weakness breeds weakness. There is no more important lesson in investing, and in fact this is the only lesson, with everything else seeking to obfuscate, or worse, to deflect and confuse.

The goal was to beat the market, to show that very strong stocks one year mean a better and not a worse expectation, and the picks, as expected, did not disappoint. Beating the S&P 500 wasn’t the goal, nor should it be anyone’s goal, we wanted to beat the Nasdaq’s 47%, which the return of our mini-index did manage by coming in at 75% for the year.

This is what you call beating the market, and if you got less than 47%, you did not, and you missed by a huge amount if you did not even beat the S&P 500’s comparatively meager 18%. What’s really funny is that a lot of people didn’t even get to 18%, like Barron’s top 10 from last year which only eked out half of that.

Undaunted, Barron’s hasn’t given up the game in spite of what should be a massive embarrassment, being beat by the Nasdaq this badly, 47% to 9%, and have come up with another sketchy list for 2021. Berkshire Hathaway is on their list again, after making nothing in 2020. Perhaps this is like rubbing a bottle that may have a genie in it by just continuing to rub it and continuing to hope, but there is no magic in this stock and it gets more terrible by the year.

Apple is in there, at least, which was one of our stocks on our 2020 list, and not surprisingly, makes our list again for 2021. Alphabet also made their list, and while it isn’t up to our standards, it’s at least a decent stock and only underperformed the market by 16%, and when we speak of the market going forward we are speaking of the Nasdaq which it is a component of.

Berkshire Hathaway lost 0.3%, so they took the full 47% hit, but this is not the worst of their current selections and is neutral compared to the real losers on their list, where breaking even became a shattered dream.

Graham Holdings is on there, which is considered to be a lite version of Berkshire Hathaway and lost 27% last year. This is the last sort of stock we should want to be in even if not for this toilet bowl worthy performance, but terrible stocks don’t scare whoever is picking these, as well evidenced by their going with Royal Dutch Shell last year when even your family pets should have known to stay well away from this sort of stock, by their sense of smell picking up the stench, and got stuck with a 35% loss.

Having the Market Beat You Screams Incompetence

This is what happens when you do not know what you are doing, when you seek not to pay attention to what is going on but try to superimpose your own reality upon these stocks, things like earnings multiples or book value or reversions that dance in the heads of the horribly confused and never make it any further.

Falling short of the averages time and again can only indicate one thing, incompetence. When we spoke of how difficult it is to beat the market for amateurs, we were including a lot of people who get paid to be amateurs, the great majority as things would have it, as the distinction here isn’t one of vocation but instead one of skill.

To pick 10 stocks out of all of the stocks in the market and come out this far behind again and again is quite a feat actually, as if you randomized the thing you at least would not be behind on average, and these disappointing results mean that you are particularly bad at what you do, to be so skilful in picking bad stocks that this could happen.

We do not have to bother going into their rationale, as the results speak for themselves, and while some might think that they are due, as if there were investing gods who feel pity for those who fail and smile upon them, that’s not how the world works, even though these are the very gods they pray to and the very prayers that are made.

We do not want to rely on prayers, especially unheard ones, and in particular, those which are not at all in harmony with reality. We like to use ideas that actually work in practice, and this means going with the fundamental nature of stocks that we spoke about earlier, that strength begets strength and weakness begets weakness.

This is not something you have to go to the top of a mountain and have God inscribe it on your tablet for you, all you have to do is open your eyes and you will see it all around you. Perhaps some think that it should not be as easy as this, as easy as it actually is, and come up with alternative approaches and refuse to admit being wrong in the face of any amount of evidence. That sums up the standard approach to investing pretty well, the standard and poor approach that is.

Just like we took on the market last year, and in particular, the Dogs of the Dow, an approach not even fit for dogs, we want to challenge these top 10 picks for 2021 with some of our own, picks that actually utilize what should be the first principle of investing but is so rarely understood.

We are traders and approach investing like trading, because it actually is just like trading, only on a longer time scale. Trading capitalizes on momentum, where we’re in a trade when it has it and are not in trades that lack it, either exiting when it wanes or deeming a trade unworthy from the start.

When we compare the Nasdaq with the S&P 500, we see the Nasdaq as having more momentum, and then put on our economist hat and understand this means more sustained demand growth. Demand growth also happens to be what puts stock prices up, so seeking this and avoiding its opposite, demand waning, is the only sensible way to go.

We regularly recommend the Nasdaq among those who prefer to invest in stock indexes, and we could just put the Nasdaq up against these 10 picks and be very confident we’ll come way out on top. Nothing is certain with investing, as we are trading in probabilities, and the probability of the Nasdaq beating them is very high, as they struggle enough to even keep up with the Standard and Poor’s 500.

That wouldn’t be much fun though, so what we decided to do instead is to start with the 22 stocks in the Nasdaq 100 that outperformed the index average. Wanting the better performing stocks as far as demand growth in 2020, and especially to exclude all those which did not measure up and underperformed the average seems like a fine idea indeed, because it is.

There’s considerably more that we could do with this list to refine it more, as we do with our own portfolios, but once again, we want to keep things as simple as possible while still pointing people in the right direction, as we did last year. We want to not only recommend, we want to teach, and we want to teach you simple ways that you can shame these amateurs. We’re therefore starting our search with stocks in the Nasdaq 100 that gained at least 50% last year, having them all on the right side of the 47% that the index gained.

We do not even want to use any discretion here or in any way leverage our expertise beyond seeking out this one principle, but it is mighty enough of a principle that we can rely on it solely with a high degree of confidence. We also wanted more than just 5 stocks this year as we realize that many investors are uncomfortable putting all their money in just 5 stocks, even though the additional potential for return when you do this greatly outweighs the marginal amount of additional risk involved.

22 is a nicer number though, although we need to realize that adding more will involve our adding in underperforming stocks relative to the index which will only water down our probability of success.

Beating the Market is Easy, Once You Understand What You Are Doing

You could teach your kids in grade school to do this, and that’s exactly what we are shooting for with these, simple principles that anyone can understand and implement. You just get the list of the performance of the individual stocks in the index, pick the ones that have a better return than the index as a whole, and jot them down.

To save you the simple trouble of doing that, here’s the list for you, with last year’s performance in brackets, year to date gain/3 month gain: Activision Blizzard (54%/13%). Adobe (51%/1%). Align Technology (88%/60%). Amazon (78%/4%). AMD (101%/13%). Apple (82%/15%). ASML (66%/33%). Autodesk (63%/30%). Baiducom (74%/74%). Cadence Design Systems (95%/27%). IDEXX Laboratories (90%/26%). JDCom (154%/15%). Lam Research (66%/46%). MercadoLibre (200%/58%). Netease (56%/5%). Netflix (62%/5%). NVIDIA (123%/-3%). PayPal (114%/18%). QUALCOMM (70%/27%). Synopsys (85%/20%). Tesla (730%/62%) T-Mobile (70%/17%).

We put in the 3 month performance to allow us to refine this a little more, and we can see that there are 5 stocks which haven’t really cut it over this time in spite of their annual return being worthy, which demonstrates that they haven’t kept up in the nearer term, something we do not want.

Once again, we will look to the Nasdaq’s performance as the benchmark, and over the last 3 months it has gained 12%. Stocks that haven’t managed at least this much have a below average shorter-term momentum, so we can use this to cross off Adobe (1%), Amazon (4%), Netflix (5%), Netease (5%), and NVIDIA (-3%). We’re now left with 17 stocks, the ones that outperformed the market both for 2020 and in the final quarter of 2020.

These 5 exclusions are still good stocks, and would likely beat Barron’s list pretty handily since they are at least going the right way over time. We prefer stocks that are outperforming now as well, and this is actually the second key to success investing on momentum, where it not only has strong momentum over a longer period, it also has it over a shorter one as well, and the shorter view is just as important, and having both going for us is what we are after.

This isn’t even a fair fight, as we’re looking at how the stocks are doing rather than relying on the completely debunked myths that the investment world in general believes and acts upon. If you prefer weaker stocks, you better prefer weaker returns. Our own preference is for stronger stocks and better returns, as odd as this may be to a lot of people.

We could hit a real bear market, which we will run away from with our own positions as we did last February, and maybe this time stay away the rest of the year. We shouldn’t have to tell you that strategies that seek to benefit from bull markets actually require bull markets, and no one should ever hold stocks when the crap hits the roof, when all bets are off and the goal turns to either laying low or seeking to profit from weakness by going short.

It’s fine to hope, but these are not decisions we need to confine ourselves to once a year, as entertaining as these exercises can be. The real key to success is to be in the best stocks when stocks are moving up, and to not be in stocks at all when things are moving the other way.

2021 is looking like it will be another interesting year, although nothing may ever top 2020 overall in the strangeness category. 2020 was a stellar year though as long as you knew to get out during the crash, and even if you didn’t, as long as you knew that when the market is strong you want to be in stocks that are strong. This should be obvious, but it is lost on just about everyone but the few that understand. Count yourselves among us now.

There was an easy extra 20% to be made from running from the COVID beast that roared and scared the wits out of the stock market, and while such shocks of this magnitude are pretty rare, we should never be so stubborn with our positions that we refuse to adapt and act when we need to, which includes slower burns that can burn even hotter over time, as bear markets often do.

Beating the “market” is actually a very simple task once you have the right foundations, and while there are skills that you can apply beyond this, skills that may take years to master and are well beyond the casual approach that investors are limited to, as long as you are on the right train, the one that is travelling in the right direction and at a better rate of speed, you will far surpass those who prefer taking the slower trains or even ones that go in the wrong direction, seeking weakness and paying the price for this.

There is a skill that good investors have which is not optional, which is the necessity to trade on reason and not fear, not being afraid of a good stock slowing down just because it is a good stock. This happens to traders as well, thinking that they are getting in late on a move and then watching it just keep going up, and with each rise, they become more and more afraid it will stop and see this fear continue to freeze them.

This is what has investors so keen on seeking “bargains,” and bargain seeking turns out to be the hobgoblin of a lot of investors’ minds, wishing they had bought Apple 20 years ago, where at every step along the way since then it is seen as “overvalued” for whatever reason, whatever delusions you want to use to confirm your false bias. You dabble in a bunch of junk instead and just make the same mistakes over and over, proudly embodying Einstein’s definition of insanity.

If fear is supposed to represent the concern of a lesser outcome, the standard and poor approach to investing is what should really be scaring us, the being happy to settle for Barron’s 9% last year instead of the 47% you could have had just by tossing your faulty ideas of stocks and just going with an index. If you want to beat this, you’re going to have to use an approach that is at least better in theory, like the one with going with the better performing stocks in the index, not one that is far worse both in theory and in practice, preferring crappier stocks and crappier results.

As easy as successful investing can be, this does not mean that we should want to be lazy, and it’s our money on the line and we don’t want to be negligent in our management of it over time either. We want to be right most of the time, but also need to be ready to run in those times where the probabilities turn against us.

We can be completely right about an investment at one point and then see it not pan out the way we had hoped, but these things change and when the weather turns, we need to continue to be committed to doing the right thing as things unfold, to not only do our best to seek the right opportunities but be ready to adapt as needed.

If we’re going to have lists for sunny days, we at least need to make sure that we pick those that the sun is shining on now, and also be ready to run for cover if and when the storms come. The fear and ignorance that pervades the investing world only exists because we have chosen to remain in the dark and keep our minds numbed. The more we think about these things, which means more than not at all, the better position we will be in to understand and prosper.

Robert

Editor, MarketReview.com

Robert really stands out in the way that he is able to clarify things through the application of simple economic principles which he also makes easy to understand.

Contact Robert: robert@marketreview.com

Topics of interest: News & updates from the Federal Deposit Insurance Corporation, Retirement, Insurance, Mortgage & more.