5 Foolproof Ideas to Beat The Market

by | Portfolio Management

Beat the Market

Everyone wants to beat the market. Volumes of books, articles, and blog posts can be found on how to “beat the market”. But is that the right goal to have? Or should you at least think about it differently?

Here are 5 foolproof ideas to beat the market in the long run:

1. Avoid Large Drawdowns

Avoid large drawdowns is the same as Warren Buffett’s famous rules:

Rule No. 1: Never Lose Money
Rule No. 2: Never Forget Rule #1

Sometimes rules seem so simple some investors have a tendency to blow it off. However there is a profound reason that Buffett and other successful investors make this priority #1.

Drawdowns cause exponentially greater damage the larger the drawdown. In other words:

It takes an 11% gain to recover a 10% loss. Not a problem.
It takes a 25% gain to recover a 20% loss. Harder.
It takes a 43% gain to recover a 30% loss. Problem.
It takes a 67% gain to recover a 40% loss. Big problem.
It takes a 100% gain to recover a 50% loss. Devastating.
It takes a 300% gain to recover a 75% loss. Catastrophic.

The best approach to make money in the long term is not losing it in the short term.

2. Implement a Adaptive Asset Allocation

Studies show that close to 90% of investment returns are determined by portfolio asset allocation. Yet most investment information focuses on choosing individual investments.

Don’t get me wrong. I spend a great deal of time looking for individual undervalued investment opportunities. Finding individual investments with a margin of safety is an important aspect of value investing. However, choosing your asset allocation is more important and therefore deserves your serious attention.

Simply stated, investment allocation is how you divide your assets between different investment classes or groups. An adaptive asset allocation provides the investor a dynamic investment allocation strategy that adjusts to favorable and unfavorable valuations. Instead of a strict fixed percentage you have greater flexibility because you can choose from a range based on valuation levels.

Different valuation levels should require a different investment allocation of your capital. One of the most important concepts in investing is to be careful or prudent about the price you pay. It’s not possible to do this without changing your allocation to asset categories after they make large price swings.

The value oriented investor would want to allocate more to assets that were priced the farthest below their real or intrinsic value. Assets that are priced above their real worth can be completely avoided or minimized.

Consider your investment allocation during the first decade of this century. Should your portfolio have held the same percentage of equities when valuations were sky high (i.e. 2000) compared to after they fell 57% in 2008-09? Of course not.

We live in the best era in history for investing. Competition has reduced transaction costs on individual investments and produced new investment vehicles (i.e ETFs). This allows investors to move from overvalued assets to undervalued assets with relative ease. It no longer makes sense to maintain positions in grossly overvalued assets.

An adaptive investment allocation is an effective means to limit your portfolio risk. During time periods when investment assets are overvalued an adaptive allocation allows an investor to “hide” in cash. Cash can help protect your portfolio in bear markets. You cannot buy low and sell high by allocating money to assets that are expensive.

Cycle of Market Emotions

At the same time, having cash available when market valuations are low provides investors the ability to take advantage of favorable opportunities. Think about how much better you would do if you bought more when prices are low and less when prices were unfavorable. Many investors do just the opposite and wonder why their long term returns suffer.


3. Require a Margin of Safety

Require a margin of safety for each individual investment. Margin of safety in an investment is the difference between the fundamental or intrinsic value and the price of your investment. “Price is what you pay. Value is what you get.” (Warren Buffett)

The larger the margin of safety the less risk you assume, the greater your potential capital gains, and the higher your income percentage (i.e. dividend or rent). A margin of safety leaves room for judgement errors, mistakes, of unforeseen adverse conditions.

Finding bargains is not always enough. We want to find companies with characteristics of good businesses: good management, strong balance sheets, innovation, competitive advantages, returns to shareholders, earnings stability, and efficient operations.

When a company is deficient in quality we have to 1) analyze the probability of the deficiency being fixed and adjust the price we are willing to pay by increasing the required margin of safety.

Be certain the company has one or more sustainable competitive advantages, otherwise your bargain may be a value trap. Competitive advantages can be key company assets, attributes, or abilities that are difficult to duplicate. These could include being a low cost provider, pricing power, powerful brands, strategic asset, barriers to entry, adapting product line, product differentiation, strong balance sheet, or outstanding management/employees.

4. Avoid Portfolio Volatility

Portfolio volatility has a large negative effect on long term returns. If you have a positive return of 50% and a negative return of 50%, the arithmetic average is 0%. But you have actually lost 25%, or one-quarter, of your portfolio.

This means that it’s in your long term interest to lower the volatility of your investment portfolio. The mathematics of compounding make it compelling to avoid downside volatility.

You should expect volatility and take advantage of it. Make it a point to understand how volatility affects performance. Here are a couple of posts that will help you understand why you MUST control your portfolio losses and reduce your portfolio volatility.

Portfolio Volatility and the Impact on Performance

Probable Maximum Loss – How to Control Investment Portfolio Losses

5. Rethink Your Time Horizon

I contend that most investors fail, in the long run, because they try to beat the market in too short of a time horizon. Investing is a marathon, not a sprint. Put less focus on short term performance and greater emphasis on high probability strategies that create long term wealth.

Yes, I want to beat the market just like anyone else. But does it matter if I outperform the market this month, or this year, or even over several years? Or, are there more important considerations?

Understanding some simple truths about mathematics can help you be successful in the long run. Personally I have beat the market only 6 out of the last 17 years (2000 thru 2016). But is that important? During that period the AAAMP Global Value (part of my retirement portfolio) has significantly out performed the S&P500!

The problem with trying to beat the market in the short term is that it causes you to invest too aggressively when prices are expensive. The more expensive the market, the greater your emphasis should be on capital preservation.

What really matters is how your portfolio performs over a long period of time. Too short of a time horizon causes investors to focus on factors other than valuation and forget their investing principles .

How your portfolio performs over your entire investment time horizon is what’s important. Long term performance requires long term solutions and valuation should be the primary determinant of your investment decisions .

Both bull and bear markets move in long term cycles. An investor will find more opportunities (bargain prices) at the end of bear markets and at the beginning of bull markets. Therefore a value investors portfolio may be more volatile during times when bargains are available. This is because you should be more aggressive when prices are low.

However, there will be fewer opportunities (bargain prices) at the end of bull markets and the beginning of bear markets. An investor should have a portfolio that is less volatile when investment prices are expensive. This is because you should lower portfolio volatility and preserve your capital when investment prices are expensive.

Implement Your Beat the Market Plan

So after all this beat the market talk I’m going to ask you to stop thinking about beating the market. If you implement sound fundamental principles and strategies, with the long term in mind, the above average returns will follow.

Additional Reading: 34 Investment Strategies & Rules to Make You a Better Investor

Value Investing Portfolio Management Guides

Arbor Asset Allocation Model Portfolio: AAAMP Global Value Portfolio, Trade Alerts

Dividend Value Builder: DVB Analyzer Newsletter, Treasure Trove Twelve Newsletter, DVB Portfolios Newsletter

Learn More

While Arbor Investment Planner has used reasonable efforts to obtain information from reliable sources, we make no representations or warranties as to the accuracy, reliability, or completeness of third-party information presented herein. The sole purpose of this analysis is information. Nothing presented herein is, or is intended to constitute investment advice. Consult your financial advisor before making investment decisions.

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