The Finance Professor

How to Consistently Beat the Market

Stock quotes in this article:MXB 

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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At the time of publication, Rothbort had no positions in stocks mentioned, although positions can change at any time.

Scott Rothbort has over 20 years of experience in the financial services industry. In 2002, Rothbort founded LakeView Asset Management, LLC, a registered investment advisor based in Millburn, N.J., which offers customized individually managed separate accounts, including proprietary long/short strategies to its high net worth clientele. He also is the founder and manager of the social networking educational Web site TheFinanceProfessor.com.

Immediately prior to that, Rothbort worked at Merrill Lynch for 10 years, where he was instrumental in building the global equity derivative business and managed the global equity swap business from its inception. Rothbort previously held international assignments in Tokyo, Hong Kong and London while working for Morgan Stanley and County NatWest Securities.

Rothbort holds an MBA in finance and international business from the Stern School of Business of New York University and a BS in economics and accounting from the Wharton School of Business of the University of Pennsylvania. He is a Term Professor of Finance and the Chief Market Strategist for the Stillman School of Business of Seton Hall University.

For more information about Scott Rothbort and LakeView Asset Management, LLC, visit the company's Web site at www.lakeviewasset.com. Scott appreciates your feedback; click here to send him an email.

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