Finance Essays Examples

How to beat the stock market? Or can we actually do that?

Just like any other investor in the market, even my trades were guided by the psychology of ‘’Want to be Warren Buffet’’. However, by the end of my trades, again like any other investor in the market I found that, ‘’There is only one Warren Buffet’’, as eventually I ended up on no-profit-no-loss situation. Although I trade in high-notch stocks such as Amazon, Microsoft, General Electric, and even the big-shot-ever-lucrative, Apple’ stock, but all I could manage is the break even. So, now I need to find, how to beat the markets? Or is it possible to beat the market or no?
No, yes! You read that right. After fortunately ending up at break-even, and going through multiple finance concepts all again, I have understood that there are only two ways to earn superior returns, and beat the market: Trading on insider information or by taking the risk (calculated risk). Talking of the former, we all know that trading on insider information is illegal in every stock market, and moreover it is very rare that we get information that will help us earn superior returns. Thus, we are left with only one option- Risk.
As proposed by Markowitz Portfolio Theory, there is a linear relationship between risk and return, thus, higher is the risk assumed, more are the chances of high returns. Even the concept is validated by Random Walk Theory proposed by eminent finance professor, Burton Melkiel, where he postulated that stock prices will have a random walk, and it is impossible for any investor to outperform the market without taking additional risk. But, risk does not guarantee profits, so I cannot just blindly invest in penny stocks and wait for the stock returns to turn superior.
Thus, the most prudent and rational way for any investor to earn sustainable returns is to deeply understand the portfolio management, and look up for long-term investment horizon. As per the foundation concepts of portfolio management, risk embedded in portfolio is made up of systematic risk (market risk) + unsystematic risk (non-market risk), and security returns are depended upon a stock’s or a portfolio systematic risk. Thus, in order to earn sustainable returns on risk-adjusted basis, the first step I need to follow is to eliminate the unsystematic risk from my portfolio through portfolio diversification by including non-correlated stocks in the portfolio. Important to note, when an investor diversifies across assets that are less than perfectly correlated, the risk of the portfolio is less than the weighted average of the risk of the individual securities in the portfolio. Eventually, the risk that will be eliminated by the diversification process will be unsystematic risk, and the one remains and that cannot be diversified is systematic risk. Hence, it was very clear that my selection of stocks for the portfolio was definitely incorrect as I had included many stocks from the same industry such as Exxon Mobil-Manitex International and Golar LNG, and Google and Microsoft. Since these stocks are highly correlated, my portfolio could not be diversified efficiently.
So, now the question remains, do I need to include all the stocks in the market universe to get a diversified portfolio. No, academic studies have shown that as an investor increase the number of non-correlated stocks in the portfolio, the portfolio risk falls to the level of market risk, and it took only 12-18 stocks to achieve the diversification benefit. Thus, once I include this much stocks in my portfolio, my portfolio will only be exposed to systematic risk, i.e. the priced risk.
i) Investment Fee:
Ok, let us assume that heeding from the portfolio diversification concept, I invest in S&P 500 index fund, where you own very small proportion of stocks of many companies, and by the end of the year your investment performs identical to S&P 500 index returns. But, here also, I will not be able to beat the markets as net of investment fee by return will be below than the market returns.
ii) Taxes:
Although every country has its own tax rates on capital gains, but just like investment fee, return earned by an investors is also cut short by taxes paid on return generated, eventually barring an investor to beat the market.
iii) Investor Behavior
Finally, the psychology of an average investors is also an obstacle that prevents him from beating the market. Out of intuition, investors buy when the markets are going up and, sell when it is going down out of fear that they will lose their capital. Such behavior of the investor prevents them from beating the markets and this quote by Warren Buffet provides us a reason as why he is successful in beating the markets:
“You shouldn’t own common stocks if a 50 per cent decrease in their value in a short period of time would cause you acute distress. If you cannot hold a stock for 10 years, don’t even hold them for 10 minutes“

Conclusion

At the end of this discussion, I have learnt that prudent stock selection of non-correlated stocks and long-term investment horizon can help me earning superior returns, and the following fact about Warren Buffet will be a valid way to end the paper:
‘’ Warren Buffett made $62.7 billion of his $63.3 billion net worth after his 50th birthday. $60 billion — nearly 95% — is from after his 60th birthday. So, think of long-term investment strategies’’

References

Fontinelle, Amy. Is it possible to beat the market? n.d. 13 April 2015. <http://www.investopedia.com/ask/answers/12/beating-the-market.asp>.
Gray, Wesley. Mission Impossible: Beating the Market Forever. n.d. 13 April 2015. <http://blogs.cfainstitute.org/investor/2014/11/06/mission-impossible-beating-the-market-forever/>.
Isle, Peter. 17 Facts About Warren Buffett And His Wealth That Will Blow Your Mind. n.d. 13 April 2015. <http://www.businessinsider.in/17-Facts-About-Warren-Buffett-And-His-Wealth-That-Will-Blow-Your-Mind/99-of-Buffetts-wealth-was-earned-after-his-50th-birthday-/slideshow/40266709.cms>.
Mohan, Mahesh. 101 “Hand-picked” Warren Buffett Quotes On Investing. 15 January 2014. 13 April 2015. <http://www.minterest.org/best-warren-buffett-quotes-on-investing/>.