How Can The Casual Investor Beat The Market

We know that stock prices fluctuate day-to-day in a way that makes almost impossible to predict its direction accurately. Well, I could predict the direction with 100% accuracy. It either moves up or it moves down.

But seriously, take any intra-day chart and you’ll marvel at how random the movement of the prices can be. They are pretty driven by the random nature of human decision making. Some day fellow A buys at this value, fellow B sells that value. Other days C buys at this, D sells at that. If any astrologist tells me they can predict the sum of all their actions, he or she wouldn’t be an astrologist already.

Speculation of stocks is a huge zero sum game, mind you. When you are a winner, someone is going to have to lose that money to you. But how is investing not a zero sum?

In between the peaks and troughs there is an imaginary line analysts like to call ‘fair-value’. It does not quite exist, at least not to the short-term speculator. What is for certain is that given good business fundamentals, ie, good management, good business model, and healthy profits, the fair-value of the company’s stocks increases over time. That is especially true for a well-diversified basket of stocks, that when summed and math-ed up, is called The Index. That is only because businesses are set up to do just one thing and one thing well. Not to make the next fashionable cell phone, not find ways to provide loans for your kid’s education, not write the most powerful 3D Operating System on Earth. Businesses are set up to earn money. When they earn enough, they dish out dividends to investors like you and me, or they buy their stock back. It’s fundamentals like these that drive the price of their stock.

So one can conclude: the index is likely to rise over time. How then do the casual investor take advantage of this invisible trend? Buy into the index and stay invested. Never mind the volatility in the middle, because it’s zero-sum anyway.

Averaging Your Investment

Still, there are times when the market goes jumping off in a Bungee rope. There are times when the true profitability of the market is the driving factor in stock prices, not the speculators. When people decide to do something silly like ram planes into structures and drop bombs on other people’s homes, the consumer somehow gets disheartened, demoralized, devastated, and what-have-you. They stop spending; businesses stop earning from consumers; and B2B businesses stop earning from other businesses; and the whole interlinked business world spirals into a sorry state called recession.

The speculator or worried investor gawks at the computer screen when his or her portfolio dives with the market. It’s time to cut losses, he or she says, and then dumps stocks frantically. Some even go Bungee-jumping same way as the market, but without the cord. Well, my friend, the best time to buy into the market is when prices are low.

How then do you take advantage of this? Set aside a fixed amount every month or every year to be invested into the index. You don’t need a calculator to figure out that: when the stock prices are high, that amount buys you less units; and when the stock prices fall, that amount buys you plenty more.

It’s called Dollar Cost Averaging, and will help you invest in a way that smoothes out the volatilities and reaps better returns. Assuming that the market gives 10% return on any investment every year, then dollar cost averaging of $10,000 a year would yield the following:

Year	Current Value	Amount Invested	Total Value of Investment
0	$0	$10,000	$10,000
1	$11,000	$10,000	$21,000
2	$23,100	$10,000	$33,100
3	Total	$30,000	$36,400

So after investing $30,000 into the market it returns you a total of $36,400. That’s an annualized 6.6% return on your investment.

There’s also this technique called Value Averaging. (Aren’t there enough jargon already in the financial world?) It’s similar to Dollar Cost Averaging, except you don’t invest with a fixed amount every time. Instead, you invest by topping up your portfolio to a pre-determined value. As a simple example, say you want your portfolio to increase by $10,000 every year. So in the first year, you invest $10,000. In the next year, if this investment had increased to $11,000, then you invest only $9,000 this time, giving you a total of $20,000. If the market in the third year rises to $22,000, then you must invest $8,000.

Year	Current Value	Amount Invested	Total Value of Investment
0	$0	$10,000	$10,000
1	$11,000	$9,000	$20,000
2	$22,000	$8,000	$30,000
3	Total	$27,000	$33,000

In the above example, assuming the same market, you would have invested only $27,000 to achieve a total return of $33,000. That’s an overall annualized 6.9% return on your investment.

This Time It’s Different

The speculator or the troubled investor always say, “This time it’s different.” Markets are too volatile today. It’s only wise to buy low, and sell high when the time is right. Trouble is, they never figured out when the lows and highs were.

These are the people who yearn to beat the market, but never did. As for the index investor, after broker commissions and what-not, you probably are just a little worse off than the index. But then again, you don’t have to beat the index; you just have to beat the speculators because they are part of the market.