In December, Fortune released its "10 Rules for Building Wealth," which contained some great advice for investors. Among them, "Don't chase trends," "Ditch credit card debt," and "Go heavy on stocks" are three I wholeheartedly agree with.
But one of them just got under my skin: "Don't try to beat the market." The rationale behind this statement was, plainly, "Even the best fund managers have trouble beating the S&P 500, so give up the chase."
Sure, if you don't want to spend time researching stocks, this is sound advice. Just buy an S&P 500 index fund and earn close to the market's return over the long run.
If you're reading this article, however, the odds are you're looking for a way to beat the market. And the good news is it might not be as hard to do as Fortune predicts.
Investing with the pack
Skeptics are quick to point out that you have a slim chance of outsmarting the highly paid, wing-tipped, pinstriped Wall Street analysts who spend all day, every day analyzing companies like Disney (NYSE:DIS), Comcast (NASDAQ:CMCSA), and Microsoft (NASDAQ:MSFT).
And they're right. Not only do these stocks each have more than 15 analysts following their every move, each also has five-year betas hovering around 1, which means their price movements were almost perfectly correlated to the market's over that period.
These stocks might be able to eke past the market in the long run, but they certainly won't be able to blow past it. They're simply too big and, more important, they're some of the largest components of the very market you're trying to beat.
You may be right, I may be crazy
Your best chance of beating the market, then, is to invest in stocks the market ignores -- that is, small-cap stocks. These stocks have only a small fraction (if any) of Wall Street's attention, which increases the likelihood that they aren't properly valued.
Over the past five years, for instance, the iSharesRussell 2000 Value (AMEX:IWN) ETF trounced the S&P 500, averaging 15.3% returns versus the S&P's 6.7%. Current top holdings in the iShares ETF include Big Lots (NYSE:BIG), Rent-A-Center (NASDAQ:RCII), and NBTY (NYSE:NTY).
If you had dedicated just 10% of your stock portfolio to this small-cap ETF, you would have beaten the market, and without much effort, too. So much for the futility in trying to beat the S&P 500.
Aim small, miss small
But as well as the iShares ETF has performed over the past five years, the ETF spreads its bets among 1,300 stocks, with no stock currently receiving more than 0.41% of assets. So even if its top holding doubles in value, it won't mean much to your returns. What's more, you're forced to accept the good stocks with the bad ones in that portfolio, some of which might be overpriced and run by less-than-honest management.
What if, instead, you hand-selected 10 or 20 stocks that are priced right and run by innovative leaders? That would give you an even better chance of beating the market.
These are exactly the kind of stocks that Fool co-founder Tom Gardner and his Motley Fool Hidden Gems team look for. Other attributes they like to see are stocks that have little or no debt on their balance sheet, lots of cash, and founders with large personal stakes.
Since July 2003, their picks have outpaced the S&P 500 by a healthy 27 percentage point margin. How's that for market-beating returns?
If you're interested in seeing their most recent picks as well as their past recommendations, simply follow this link for a free 30-day trial to the service. There is no obligation to subscribe.
Todd Wenning wishes the St. Joe's Hawks luck against arch-rival Villanova tomorrow night. The Hawk Will Never Die! He does not own shares in any company mentioned. Disney is a Motley Fool Stock Advisor choice. Microsoft and Rent-A-Center are Inside Value picks. The Fool has a disclosure policy.
