Do individual investors have a reasonable chance of beating the market? Many out there say no. I say yes. Certainly not everyone can beat the averages by definition, but those who put their minds to it have a reasonable chance.
Now, this isn't exactly big news. We've been saying it for years at The Motley Fool. But some very compelling arguments counter our belief.
The naysayers
The most famous comes from Burton Malkiel, author of A Random Walk Down Wall Street. This is such a good read that I recommend it without hesitation, even though I disagree with his basic premise that it's difficult or impossible to beat the market over the long run.
Or how about Princeton professor Daniel Kahneman? When asked about individual investors beating the market, he said simply, "They're just not going to do it. It's just not going to happen." Kahneman may have some idea what he's talking about; he's a Nobel Prize winner in economics.
Generally speaking, these people subscribe to the Efficient Market Theory, otherwise known as EMT. The theory has many forms, and there are different interpretations of each form, but in a nutshell, EMT proponents believe:
- There is no way to consistently predict future price movements from past results.
- All relevant information about a company is already reflected in its stock price, and the price reacts to any new information by adjusting quickly.
- Because prices are so efficient, a blind orangutan throwing darts at a list of stocks has just as good a chance of beating the market as someone who puts hours of work into the process. (Malkiel uses "blindfolded monkey" in his book, but I like my example better.)
The yeasayers
Legendary investors such as Warren Buffett and Peter Lynch believe individuals can beat the market, however. Each, in racking up outstanding returns over many years with stocks like Coca-Cola (NYSE:KO), Washington Post (NYSE:WPO), and Fannie Mae (NYSE:FNM), have lighted the path for the rest of us with their clear and sensible strategies. David and Tom Gardner have taken many of these strategies to heart in Motley Fool Stock Advisor. Nearing the newsletter's third anniversary, their picks have returned an average of 63% vs. 22% for like amounts invested in the S&P 500.
Investing on your own in individual stocks is not something to be taken lightly. It requires a lot of effort. If you don't want to spend several hours going over numbers, reading reports, discussing the company on our boards, etc., then you shouldn't even think about it. In that case it would be best to either stick with indexing, or consider letting trusted experts do the research for you, as the Gardners do in Stock Advisor.
However, for many, stock research is a stimulating and enjoyable process. There is a great satisfaction that comes from learning and growing and stretching the mind ... even more so when the effort goes toward bettering your financial standing.
Become an expert on a
few
companies or industries
One of the keys to being a successful investor is not stretching yourself too thin. It's better to start slowly, learning all you can about a company you're interested in. If you decide not to invest in it, that's fine. You've gained some valuable knowledge. If you do invest, perhaps start off with just a few hundred dollars. (There's no one right answer for what percentage of your portfolio a single stock should comprise, but smaller is more conservative.)
After that research, start again with another company and repeat. This process will guard against building a portfolio of many companies that you know little about, which is a dangerous thing. Instead, you'll own a few companies you know a lot about.
In his book The Future for Investors, Jeremy Siegel -- another legendary investing expert who believes individuals can beat the market -- said that the 20 best-performing survivor stocks from the original S&P 500 in 1957 are all dividend payers that most everyone is familiar with. Among these "corporate El Dorados," as Siegel calls them, are PepsiCo (NYSE:PEP), Hershey Foods (NYSE:HSY), Merck (NYSE:MRK), and Tootsie Roll (NYSE:TR). Companies like these -- durable dividend-paying household names with a long track record of success -- are great places to start your research.
Follow the experts
I firmly believe that people who enjoy learning and who are able to apply this slow, disciplined approach stand a reasonable chance of beating the market averages. It's not easy, but it can be fun and rewarding.
And the best part is this: Even if you don't have the time and inclination for all this research, index funds are ready and waiting for you, virtually guaranteeing market-matching performance with little effort on your part. And if you're not content with matching the market, consider taking part in the outstanding Stock Advisor service. Again comparing against the S&P's 22% returns, Tom's recommendations are up an average of 76%, and David's 50%. You can see all of their picks and read about the strategies behind them with a 30-day free trial.
This article was originally published on Jan. 17, 2003. It has been updated.
Rex Moore asks you to hold your applause until all contestants have been introduced. At time of publication, he did not own shares of any company mentioned in this article. Coca-Cola and Fannie Mae are Motley Fool Inside Value recommendation. Merck is a Motley Fool Income Investor recommendation. The Fool has adisclosure policy.
