How to Consistently Beat the Market

For example, suppose we have a simplistic market of five stocks: A, B, C, D and E. On average, the return for all five stocks will equal the market return. However, if we can identify which one or two of these stocks will underperform and exclude these stocks from our portfolio, then we will almost certainly outperform the market.

We also have to be careful not to make selection or rejection errors. In statistics, there are two types of errors that can occur in the decision process:

• Type I: Statistically speaking, this is a rejection of the null hypothesis when the null hypothesis is true. In layman's terms, this is what we call a false positive. We accept something that is incorrect. A type I error occurs in investing when we accept an investment that will perform poorly. This is a more costly error to investors. Clearly, we want to avoid Type I errors.
• Type II: Statistically speaking, this is a failure to reject the null hypothesis when the null hypothesis is false. In layman's terms, this is what we call a false negative. We reject something that is correct. A type I error occurs in investing when we reject an investment that will outperform the market. Type II errors are more difficult to avoid and tend to be less costly. Nevertheless, we want to avoid type II errors if possible.

Homework

1. Carefully define your benchmark and asset class when developing an investment strategy. Manage that portfolio within the context of the benchmark selected.
2. If you cannot on a consistent basis outperform the market, then you might be best served by hiring a professional to do so for you.
3. Try to deselect underperforming investments and avoid type I errors.

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