Beating the stock market is widely regarded as the crown jewel of investing. Many try and fail. There's a reason why 90% of actively traded funds underperform their benchmark. No one has a crystal ball. As long as human emotions permeate the halls of the New York Stock Exchange, the rows and columns of online brokerage accounts, and the thumbs of Robinhood investors, the stock market is going to do some crazy things.
Here's the one simple secret you need to know to beat the stock market, as well as some tools you can use to stay on track through the ups and downs.
Trying to beat the stock market is the worst way to beat the stock market
It sounds counterintuitive, but actively trying to beat the stock market in the short run is actually one of the worst ways to beat the stock market. It can lead to short-term thinking, putting too much emphasis on quarterly performance, falling prey to market trends and volatility, and losing sight of long-term investing theses.
Actively trying to beat the stock market every year inflates the importance of short-term randomness and discounts growth trends. A focus on Amazon's net income in 2005 would have ignored the paradigm shift toward e-commerce and cloud computing. Obsessing over the cosmetics of the iPhone 5C in 2013 could have led you to miss out on Apple's sixfold share appreciation over the last eight years.
Quarterly performance isn't the be-all and end-all, but it does have some value -- namely for keeping track of the long-term investing thesis. In the case of United Parcel Service (NYSE:UPS), its last few quarters illustrated the power of the company's fleet expansion, e-commerce push, and highly profitable international segment. The company has been able to deliver impressive results that strengthen its five-year to 10-year plans.
The dynamics of a market rally
Each market rally or downturn is led by certain sectors more than others. Last year, tech and consumer discretionary stocks contributed the bulk of the S&P 500's and the Nasdaq's gains. This year, energy and industrial stocks, financials, and materials stocks are gaining traction while growth stocks are plummeting.
Warren Buffett has joked that he's likely to underperform raging bull markets because he keeps a lot of cash and doesn't like to overpay for stocks. And sure enough, Berkshire Hathaway (NYSE:BRK.A) (NYSE:BRK.B) has underperformed the market over the last decade. But that doesn't make Buffett a bad investor.
If you're a value or income investor at heart, it would have been very hard to outperform the market last year. The same goes if you're a small-cap growth investor this year.
Trying to beat the market every year can lead to investing in businesses you don't understand or taking on too much risk in the pursuit of outperformance. It's one thing to learn about a new business or diversify your portfolio, but speculating can lead to bad things.
What great investors do
Buffett and Cathie Wood have starkly contrasting investing styles. But both Berkshire Hathaway and Ark Invest focus on long-term growth trends, not short-term cycles.
Buffett's classic value bent has led Berkshire Hathaway to produce one of the most impressive multidecade track records in market history.
Ark Invest's 2021 Big Ideas presentation didn't focus on what price Bitcoin was going to be a year from now or whether Elon Musk would nail his SNL debut. Rather, Wood and her team looked out to 2030 and beyond to try and pick the 15 best sector growth trends. And then from there, select the stocks they think have the best chance of success.
Aside from Buffett and Wood, former Fool Morgan Housel stresses the importance of playing the long-term game in his book The Psychology of Money. To paraphrase, Housel acknowledges that there are many investors who don't care at all about fundamentals or long-term trends and are just day trading for a quick buck. These investors and can move the needle significantly, so it's important to be aware of their power without playing into their game.
Tax consequences of trying to beat the market
Actively trying to beat the market can be bad for your portfolio and raise your bill to the IRS. That's because short-term capital gains are taxed at a higher rate than long-term capital gains and dividends.
Switching in and out of sectors and catching the latest growth trend can rack up the tax bill in a hurry. Fractional shares and $0 trading fees are fuel for day trading daredevils. But they can also act as tools to gain a lower entry point into a high nominally priced stock like MercadoLibre or start a position in a new stock.
The through line in investing
Whether it's psychological, material, or tax-based, trying to beat the market every year misses the bigger picture. Ten or 20 years from now, you're not going to care whether you beat the market in 2021 or not. All that matters is value creation, quality of life, and having the nest egg needed to live a fulfilling retirement. The stock market is one of the best ways to compound wealth over time. Beating the market in a given year is little more than bragging rights.