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3 Secrets to Beating the Average Investor
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3 Secrets to Beating the Average Investor

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3 Secrets to Beating the Average Investor

It's a surprising statistic, but in the average year, more than 80% of the United States' actively managed mutual funds underperform the broad market. It's a surprise simply because these funds are managed by trained (and well-paid) financial professionals.

The funny thing is, while the equivalent data on individual "retail" investors is a bit fuzzier, most of them don't keep pace with market benchmarks like the S&P 500 (SNPINDEX: ^GSPC) either. What gives? After all, the industry's collective marketing message is that an empowered investor is equipped to produce above-average results.

There are three things market-beating investors do that most market-lagging investors don't. And all three are things anyone could begin doing today.

Image source: Getty Images.

1. Truly commit to holding for the long haul

Lots of people say they're in stocks for the long haul. A sizable portion of this crowd, however, is lured into the short-term trading dance by a scintillating story. Big mistake.

Take Roku (NASDAQ: ROKU) as an example. The streaming TV device maker's 2017 IPO preceded what eventually turned into more than a 100% gain at 2019's peak price near $176 per share. Some people understandably took profits then, right in front of a sharp pullback. Other people locked in lesser gains during the stock's lethargic -- and mostly bearish -- period through early 2020.

All of them should have stuck with the game-changing consumer technology company, though. The stock soared to a high of nearly $500 per share earlier this year, which at the time was almost a 3,000% run-up from its very first trade as a publicly traded company.

Rewarded patience is only part of this lesson, however.

Ever heard of the Pareto principle, sometimes called the 80/20 rule? It applies to the investing world as well -- around 80% of your gains will come from roughly 20% of your positions.

The catch: You don't know which 20% of your stocks will do the heavy lifting. You just have to be willing to leave things alone when one or more of your holdings starts going ballistic.

2. Bet against the crowd when the crowd is most certain

Trying to time the stock market's short-term peaks and troughs remains a famously bad idea. Not only is it difficult to do, many people end up doing themselves more harm than good with their timing efforts. That's because what look like near-term highs and lows are often neither of those things in the end.

Think back to March of last year. Investors were selling in a panic because they just didn't know what sort of havoc the coronavirus outbreak might create. We now know that buying in the midst of that panic was brilliant, as the global economy wasn't fundamentally broken. The world just needed a little time to work around the pandemic and stimulus money to take the edge off the shock.

Figuring out how to navigate shock events can be tricky. But when you're talking about a long-term cyclical peak or trough, things are simpler. These economic ebbs and flow are to be expected every few years, and investors show similar levels of fear and greed at each high and low.

Take 2009's rebound from the subprime mortgage meltdown, for example. That's when the S&P 500's Volatility Index was at record levels, as was the American Association of Individual Investors' bearish sentiment. Both were signs that almost all investors believed things could only get worse from there. As we now know, however, that sentiment actually signaled a cyclical bottom for stocks, reflecting feelings about the recent past rather than reflecting the plausible future.

The idea works in reverse as well. Consumer confidence was at multi-year highs in mid-2007, for instance, just before the subprime mortgage collapse dragged the market lower with it. Most of us were simply ignoring the economic red flags waving at the time, like hedge fund failures, untamed inflation, and surprisingly strong market sell-offs that indicate indiscriminate dumping of stocks.

Sure, sentiment is pretty healthy right now too. It's not at levels that suggest it's time to sell, however. Aside from the fact that consumer confidence is still lingering well below record highs, investors aren't ignoring any potential economic pitfall -- they're all being priced in. Earnings are growing nicely again as well, pushing past the headwind caused by the pandemic.

The toughest part of this tip is simply trusting your guts against opposing messages.

3. Make a diversification plan, and stick to it

Finally, while many investors make tentative plans to diversify their portfolios across several asset categories and classes, not enough investors fully execute those plans. And the ones who do don't compare their holdings to that plan often enough, updating as needed. This sort of care takes time, which takes time away from more satisfying and gratifying activities like stepping into a hot stock. That's why it's so easy for a portfolio to become dangerously lopsided as the days turn into weeks, and weeks turn into months.

The above-average investor, however, knows this sort of mundane rebalancing activity is worth the time devoted to it.

Mutual fund managers at Hartford crunched the numbers early last year, comparing a regularly rebalanced 70% stocks/30% bonds portfolio to the same starting portfolio that was never rebalanced. After 20 years, the regularly rebalanced portfolio was 8% bigger than the never-rebalanced one.

The 8% difference between a regularly rebalanced and never-rebalanced portfolio may not seem significant. If you're talking about a $1 million portfolio, though, this isn't chump change. Also bear in mind that Hartford was only using the S&P 500 Index and the Bloomberg Barclays US Aggregate Bond Index as a very simple test portfolio, ignoring the effect of sector and market-cap diversification. The more detailed your allocation plan is, the more it can benefit you... as long as you stick to it.

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James Brumley has no position in any of the stocks mentioned. The Motley Fool owns shares of and recommends Roku. The Motley Fool has a disclosure policy.

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