There are three ways to beat the market:
- Know something no one else knows
- Process known information better that the collective wisdom of the market
- Exploit a structural or psychological anomaly
The first one is generally insider trading, but maybe on occasion you can learn something relevant unknown to the marketplace at large. (I had it happen once with a microcap company that I was involved with as a corporate customer.) The second one I think is pretty much impossible. On occasion someone may think something different from the market and might even be right, but I suspect that they would be wrong as often as right. In other words, it’s luck not skill and won’t lead to excess returns.
The third item is where we think there are opportunities. I have two standard examples of each:
- Structural anomalies
- Barely non-investment-grade bonds
- Low volatility stocks
- Behavioral anomalies
Let me talk about the structural ones briefly. Many investors are not allowed (by law or charter) to own non-investment-grade fixed income (i.e. junk bonds). Active managers need high returns to make up higher fees so they will own deeper junk to try to make those returns. Thus BB bonds are “under-owned” and may have a higher risk-adjusted return than other bonds. Similarly, many active managers have a benchmark such as the S&P 500 and people don’t really do a risk-adjusted return comparison, they do an unadjusted comparison. So the managers, needing alpha to at least make up the fees, will buy higher beta stocks. It’s not skill it’s just another way to get leverage. They (generally) are limited to being long-only and not using explicit leverage so they can’t really own low-beta stocks even if the risk-adjusted returns are higher.
As far as the behavioral anomalies, people like owning exciting growth stocks (aka “story stocks” or “lottery ticket stocks”) thus the expected returns on those investments are, on average, poor. (Just as with the lottery someone will likely be a winner, but on average people will lose.) Value stocks win because people really don’t like owning boring, stodgy, or distressed investments. Thus those investments have tended to outperform in the long run (again on average). Momentum has a few behavioral explanations. Investors may under-react to new developments, or assume too much short-term mean reversion (a term I dislike) in the short run. People also like to win and don’t like to lose, but they tend to frame their winning and losing irrationally. If an investment goes up, they sell quickly to “take the win” and if it goes down they hold on so they don’t have to admit (if even to themselves) that the investment didn’t work out. It just didn’t work out yet. Large numbers of investors doing those things will keep investments from rising or falling as much as they should initially which leads to momentum.
It’s important to know where you have an edge. Knowing something or understanding the implications of what you know better than the collective wisdom of all market participants is highly unlikely to be one despite the amount of effort spent on those activities. (Indeed, the amount of collective effort spent on those activities by market participants is precisely why an individual is unlikely to succeed by doing them!)