If you’re an investor in index funds, like I am, then you probably believe that it’s impossible to beat the market in the long run. You’ve had everyone from bloggers to Warren Buffett tell you the best thing for you is to invest in mutual funds indexed to the market. We do this because we believe the market is unbeatable. This is the belief in the so called “Efficient Market Hypothesis“. Basically we’re saying that stock prices already reflect all available information and it’s impossible to outperform the market return through stock-picking or market timing.
But that ain’t all true my friends. The actual truth is there are many people out there that can beat the market. Hundreds, perhaps thousands of them actually. The problem is you haven’t heard of most of them, and you never will. Why? Because that is what they want. You see, to beat the market on a regular basis you have to be small enough that no one pays attention to what you are doing. Otherwise people start to notice, and then they start copying. When you’re small you can do things that larger funds cannot. Fidelity Magellan is one of the largest mutual funds on the planet, any investment change they make is immediately noticed by the market, and the efficient market rules take over killing any potential returns.
There are other ways to beat the market other than being small. You need to invest in securities that have nothing to do with the market though. Have you ever heard of cat bonds? Nope we aren’t talking lolcats my friends, cat is short for catastrophe. An insurer can issue cat bonds to investors that help the insurance company avoid some of the losses in the case of a big disaster, like hurricane or earthquake. To investors these bonds pay pretty well.
There are other investments too. Some hedge funds have been making a killing by purchasing up mortgages from struggling banks. Imagine buying a $400,000 mortgage on a house worth $250,000 for the small price of $100,000. This isn’t a joke. That is a killer return. Many of these investors are making returns above and beyond the S&P 500, and they do it every year consistently.
However most successful investors that regularly beat the market are not talking about a simple four-letter word we often forget to discuss. RISK. Many of these mortgages are very risky — cat bonds are too. Many of the stock investors that beat the market use borrowed money called leverage to increase their returns. However if they lose money they still have to pay back the borrowed funds. This has wiped out many investors over the last few years.
So what’s a small investor like you supposed to do? The market is beatable even without all of that fancy high-risk stuff. There are people out there that regularly beat the market. Should we find them and invest? Not a chance. It’s not worth your time. Index funds are simply good enough. For small investors there is no better vehicle than a quality low-fee index fund.
Just next time someone tells you it’s impossible to beat the market, just give them a wink and say you’re invested in hurricane cat bonds for the residents of Las Vegas and the coupon is 1% greater than the S&P 500 historical return. Watch their eyes go wide with confusion and walk away. I’m in index funds and you should be too.