Reprinted courtesy of marketwatch.com.
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Beating the market is easy
Beating the stock market is the holy grail for many investors, and it's not hard.
You can try to beat the market through luck, just as you can win the Powerball lottery by mere luck. Better still, you can beat the market through knowledge and discipline. I'll show you how.
The average investor is actually very unlikely to beat the market. Many people let their emotions (mainly greed, fear and impatience) stop them from doing the right things. Others fall prey to Wall Street's sales pitches. Still others, unfortunately, just don't know what they're doing.
Most experts regard the Standard & Poor’s 500 Index SPX -0.41% as "the market." Some studies indicate that only one-in-20 investors beat that bogey over long periods. That includes professionals.
The evidence: The most recent DALBAR study found that in the 20 calendar years ending in December 2011, the Standard & Poor's 500 Index had a 7.8% compound rate of return. In that same period, the average investor in U.S. equity mutual funds earned just 3.5%.
However, if you have reasonable expectations and you don't demand immediate results, beating the market is a piece of cake!
10 ways to beat the market
One: The most obvious way to beat the index is with leverage. Sure, investing with borrowed money is risky, but that's true of any investment. If you invest $10,000 of your own money and add 10% margin, $11,000 goes to work for you. After the cost of borrowing, that can probably add 0.2 to 0.4 percentage points to your annual long-term return.
But I hope you won't overdo it. Don't use more than 25% leverage. That could add more than 1% to your long-term return without too much risk of a margin call.
Two: Want more? Skip the S&P 500 Index and substitute a large-cap value fund such as the Vanguard Value Index VIVAX -0.22% . Over the long term, that will (at least based on history) boost your expected return by 1%.
Three: Another way to seek that extra one percentage point is to invest in a REIT fund like the Vanguard REIT Index Fund VGSIX -0.05% . That will give you a dividend-based return in an asset class that's not highly correlated with the overall stock market.
Four: If you want extra long-term horsepower to leave the S&P 500 Index in the dust, put your money in a fund such as Vanguard's Small Cap Index Fund NAESX -0.18% . Over the long haul, small-cap stocks have bested the market about half the time. This is an especially good choice for younger investors.
Five: If you want to try for still more, substitute small-cap value stocks through a fund such as the Vanguard Small-Cap Value Fund VISVX -0.06% . Over the past 80 years, this asset class has beaten the S&P 500 Index by three percentage points annually.
Six: Go beyond the borders of the United States. International large-cap value stocks, available in the Vanguard International Value Fund VTRIX +0.61% , have about the same historical advantage as U.S. large-cap value stocks.
Seven: International small-cap value stocks, like their U.S. counterparts, have historically beaten the S&P 500 Index by about three percentage points in the long run. The Wisdom Tree International Small Cap Dividend ETF DLS +0.41% gives you easy access to this asset class.
Eight: Most experts expect emerging market stocks to beat the S&P 500 Index. This doesn't happen in every year or even every decade, of course. But over the past 10 years, emerging markets stocks have clobbered the S&P by more than 10 percentage points a year. A long-term advantage of 2% to 3% isn't unreasonable to expect.
Nine: Do what I do with the equity part of my own portfolio: Invest in the S&P 500 Index as well as each of the other asset classes I have mentioned. I learned from the academic community, and I have confirmed with the best long-term data I can find, that this combination beats the Standard & Poor's 500 Index by about 2% a year without any added volatility. More gain without more pain — a combination I find very appealing at age 69.
Ten: Whatever approach you use, carry it out with low-cost funds, not individual stocks. I have been talking to investors for more than 50 years, and most of them have believed they could pick stocks that beat the market. Yet I've never met even one who could articulate a stock-picking strategy that reliably beats the market.
Maybe you will be the first to do that. But remember this: A recent national lottery that produced two winners also produced 175 million losers — and many times that many losers if you count all the drawings in which every player was a loser.
You can do much better than that, and now you know how.