Question

Explain what it means to “beat the market.” Why do many individuals -- both academic and nonacademic -- believe that such is not systematically possible? Please be thorough. What may move you to temper this view? Be very detailed on your explanation?

Answer 1

By the term Beat the market, we mean to say that earning the return on investment which exceeds the performance of the market indexes.

When we think about beating the market, one term which comes across is 'Efficient Market Hypothesis'. It is a theory which states that all information available in the market is reflected by that particular asset price. Its implication is that it is impossible to beat the market consistently on a risk adjusted basis since the market prices will change only when new information comes across.

However, when we talk about investors' perspective it is possible only for one in many cases. Some large scale investors manages to get better returns that the market indexes. Buying the stock is the first step of the process. They buy the stake in huge quantities through which they can influence company decisions. This benefits the investor and they earn higher profits than the overall market. Moreover, this might benefit in one more way, as the market prices will rise (for short term) and they can sell it and earn a quick turnaround. However, the above described way is not accessible to individual investors with relatively less capital.

An individual investor might not earn higher returns than the market returns because of the following reasons:

a. We cannot predict the future contingencies which includes earthquakes, calamities, shortages of material or any innovation by some other company. It contributes a lot to the changes in the market prices of an asset. We safegaurd oourselves by hedging against all or some of the factors. However, when we hedge against each and everything, we end up having small investments in everything which results in returns which are equivalent or sometimes less than the market return.

b. By investing in mutual fund, the managers promise higher returns but in return of high fees. This results in higher return targets as it may leave us behind the market, it it it fails to achieve a specified target.

So, when we look at these factors, it is surprising to 'beat the market' consistently. It is advisable to invest with the thought of earning market returns rather than outperforming the markets, as it may result in underperformance.