The Motley Fool

2 Great Tips to Beat the Stock Market

With markets getting more efficient, investors are finding it more challenging to beat the market through active stock selection. Even esteemed investor Warren Buffett has said that average investors would probably be better off investing in index funds, rather than managing their own stock portfolio.

The fact that actively managed funds have on average lagged market returns further emphasises this fact.

So with that in mind, is it still possible for retail investors to outperform the stock market over the long-term?

Think extremely long-term

Investors often try to beat the market by finding underpriced stocks. However, underpriced stocks could mean three things: 

  1. The stock is underpriced relative to its assets;
  2. The stock is underpriced relative to its current earnings; and/or
  3. The stock is underpriced relative to its long-term growth potential.

Analysts more-often-than-not forecast the earnings of shares over the next one to two years. As such, stock prices will reflect these short-term growth projections.

However, stocks that can sustain growth over a much longer time frame may have prices that do not reflect this growth. 

Because of this, investors who are able to pick stocks that are underpriced relative to their long-term growth potential would be able to achieve market-beating returns over the long-term. 

Due to the short-term forecasts of most sell-side analysts, the universe of stocks that fit this third criterion is actually quite large. Investors who are patient enough to let these stocks compound over time will very likely end up with a market-beating portfolio.

That being said, a word of caution: Companies may not always live up to their potential. As such, investors should diversify their stock selection across a wide range of stocks that fit this mould.

Embrace volatility

Volatility is part and parcel of the stock market.

Even the biggest stock winners are not immune to big drawdowns. Take Amazon.com, for instance. The e-commerce giant’s stock appreciated a staggering 76,000% from 1997 to 2018. But over that same time frame, it experienced peak to trough declines of between 12.6% to 83.6% each year. 

In essence, that means the stock had a double-digit drawdown every single year. If investors bailed at every sign of trouble, they would never have managed to get the long-term returns that Amazon afforded patient investors. 

If stocks were not volatile, investors would simply pour money in until the returns of stocks match that of other less volatile asset classes.

The Foolish bottom line

Beating the stock market needs more than just choosing the most well-known stocks in the market. It requires investors to find underpriced stocks relative to their five or even 10-year growth trajectories. As market participants do not normally have such long-term views, there are plenty of stocks that fit this bill.

However, investors who want to beat the market must contend with volatility and not be afraid of big drawdowns. By letting these stocks compound over time, even the average retail investors will likely be able to outperform the market through superior stock selection.

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The information provided is for general information purposes only and is not intended to be personalised investment or financial advice. Motley Fool Singapore contributor Jeremy Chia doesn’t own shares in any companies mentioned. The Motley Fool Singapore has a recommendation on Amazon.com.