Using money to make money in markets is the ultimate goal of investing. Markets operate at certain levels based on economic factors, investor sentiment, and national or global events. Investors work to find ways to outperform the market using various methods involving financial mathematics and statistics to determine outcomes and reduce the inherent risks of investing.
Market Risks
No matter the conditions facing the markets, there are always risks when investing. Investment prices can rise or fall depending on economic conditions, political actions, or natural disasters. Prices fluctuate with these factors because investors believe that the issuers of investments will struggle to maintain profitability if their businesses are affected. This belief is known as investor confidence.
Market confidence is heavily reliant on the personal sentiments of investors, which are shared among them. These negative sentiments are contagious enough to lead to panic – resulting in massive selling and declining prices, even stock market crashes.
One example of market risk is the pandemic of 2020, which forced governments to impose stay-at-home orders on populations in an attempt to control the spread. This caused a decline in investor confidence and resulted in a market crash. The market officially became a bear market, then started to rise in a wave-like manner during a recovery process.
There are other examples of market crashes and corrections throughout the twentieth century and the beginning of the twenty-first century. The 1929 crash, the housing bubble burst in 2007, and its subsequent crash in 2008 are two notable instances of collapses that turned into recessions and caused many unprepared investors to lose everything.
To mitigate the risks of the unknown, investors can take actions that help them reduce losses, or even achieve gains during periods of market downturns and corrections. These actions are usually of low to moderate risk and involve some planning before any market downturn occurs, except for the strategic decision to continue purchasing value investments regardless of market fluctuations.
It should be noted that while these techniques can help investors weather collapses and corrections, there is no guarantee that there will be any returns or gains due to the inherent risks of investing.
Low to Moderate Risk Strategies to Outperform the Market
Diversifying your portfolio is considered one of the most accepted ways for the individual investor to outperform the market in the long run. An investor can diversify their portfolio by purchasing eight different assets that react differently to business cycle stages.
For example, when the economy enters a recession, some assets may rise in value (typically bonds and gold), while others may decrease in value (such as stocks). The reverse will happen during an economic recovery, where stocks increase in value and gold drops in value. This will offset the risks associated with investing in each type.
Choosing stocks using value investing techniques is another method that proponents claim can outperform the market. Investment icon Warren Buffett successfully uses this strategy by purchasing controlling shares in companies with high profit margins, clear competitive advantages, and management that he respects.
Note: The most cited stock selection strategy by Warren Buffett is value investing.
Buffett prefers stocks that are ignored by many investors because the value that can be placed on them is not immediately apparent or based on yield. For this reason, he seeks investments in time-tested, generally boring companies like Johnson & Johnson or Kraft Foods – also known as toothpaste stocks.
Methods
High Risk
Some other methods that are traded in the investment community include active mutual funds, alternative investment funds, day trading, and market timing. These methods can be profitable for some investors – generally those with large financial stakes or professional tools and training – but for most investors, they represent a level of risk that cannot be realistically mitigated.
Active Mutual Funds
Active mutual funds justify their high fees by claiming to outperform the market. Fund managers use strategies that attempt to make their investment returns better than other funds. They also employ teams of financial analysts, market researchers, and data analysts to help find the stocks with the highest returns for the fund.
The risk lies not only in chasing returns but also in the fact that active mutual funds generally have high asset turnover within the funds – which increases the risk of high taxes as well as high fees if you have any returns.
Note: Short-term returns (returns within a 12-month period) are taxed as ordinary income, which is a higher tax rate than capital gains tax. Trading within the fund can lead to short-term returns.
Alternative Investment Funds
Alternative investment funds are investments pooled together to try to “hedge” investment risks by working towards achieving consistent returns. Alternative investment funds claim to achieve above-average returns using a diverse array of securities, derivatives, and other investment tools in an attempt to generate positive returns regardless of market fluctuations.
A derivative is an investment whose value is based on an underlying asset, such as stocks or bonds. Sometimes, funds use leverage or debt to try to outperform the market.
Note: Alternative investment funds are generally considered riskier than other funds, which is why they are restricted to those who have substantial financial resources.
Day Trading
Day traders also hope to outperform the market. They use formulas and some forms of financial analysis and chart patterns – such as “Cup and Handle” or “Inverse Head and Shoulders” – to buy and sell stocks, options, or derivatives throughout the day.
They study news, events, and price trends to help them buy low and sell high throughout the day before the market closes. However, studies indicate that most day traders do not make good profits. In one study, it was found that 97% of day traders lost money – only 3% of traders made profits regularly, most of whom were high-frequency professional traders.
With stock options, the trader does not need to put up 100% of the stock’s value to purchase it. Instead, the trader can obtain an option to buy it at an agreed-upon price by a certain date. Often, they only have to pay between 2% and 10% of the contract in a margin account.
Note: Margin accounts are accounts where brokers set a minimum amount of capital that must be maintained regardless of market conditions. Day traders often lose money on trades and lose value in their margin accounts. They then need to put more money into the margin account, costing them additional capital.
If the value of the underlying asset rises, the trader waits until the contract expires. Ideally, they buy the stock at a low price and then sell it immediately at a higher price, taking the difference. However, if the asset price drops, traders must add funds to keep their options open. If the price does not rise by the expiration date, they could lose the entire fee as well as the money that needs to be replenished in the margin account – if they drop below the minimum threshold set by their broker.
Market Timing
The Market
Wouldn’t it be better to put all your money into certain investments during a bear market, then switch to a bull market strategy when the market starts thriving? This is the technique many investors try to use if they don’t have the patience to wait during the ups and downs of the market.
This is known as market timing. In theory, it can work – if you are able to calculate and predict market fluctuations and turns. The ability to predict and time the market is the ultimate goal for investors – they have been trying to find ways to do this since the beginning of investing.
The Safest Way to Outperform the Market
Among the many options investors have to make money, diversifying your portfolio and using proven techniques such as value investing – each takes time to build wealth. The key factors required in these methods include patience and the ability to resist panic selling when the market takes a downturn.
Was this page helpful?
Thank you for your feedback! Let us know why! Other
Sources:
The Balance uses only high-quality sources, including peer-reviewed studies, to support the facts in our articles. Read our editorial process to learn more about how we verify facts and keep our content accurate, reliable, and trustworthy.
Warren Buffett. “Letter to Shareholders, 2019,” page 4.
Warren Buffett. “Shareholder Letters, 2008,” page 15.
Investor.gov. “Alternative Investment Funds.”
Investor.gov. “Updated Investor Bulletin: Accredited Investors.”
Fernando Chagou, et al. “Day Trading to Live?”
Source: https://www.thebalancemoney.com/outperform-the-market-3305874
Leave a Reply