The Risks and Rewards of Trying to Beat the Market

Actively trading markets is an enticing challenge for those trying to achieve returns beyond what a standard diversified portfolio might offer.

After all, if you’re reading this article, you probably think you can actively trade and add value over simply passively holding index funds.

Yet, the pursuit of “beating the market” is complex and full of potential risks.

We look at both the rewards and pitfalls of deviating from a basic long-term investment approach, as well as why market timing and making non-consensus calls can be so difficult.

Key Takeaways – The Risks and Rewards of Trying to Beat the Market

• Non-Consensus Calls – Taking unique positions outside market consensus can yield higher returns, but it requires skill and insight and is difficult to do.
• Costs and Risks of Active Trading – Active trading involves transaction costs and risks, which can erode returns if not carefully managed.
• Luck vs. Skill – Success in active trading often reflects luck as much as skill, and overconfidence can lead to excessive risks.
• Diversification Provides Stability – A diversified portfolio provides consistent returns without the need for market predictions. It can serve as a structured baseline, even in the context of a strategy/portfolio that attempts alpha generation.

The Value of a Diversified Portfolio

Diversified Portfolios

The best starting point in any investment discussion is the value of a diversified, long-only portfolio, also known as a “beta” or portfolio.

A beta portfolio, which holds a broad mix of assets, is typically structured to deliver a consistent, average market return over time.

We talked about this more here (the concept of balanced beta).

For most, this should probably be the only investment strategy for individuals building wealth, as it eliminates the need for complex market calls or active management that attempt to beat the market.

Essentially, owning a diversified beta portfolio offers stable returns without requiring active market prediction.

The Risk of Deviating from a Beta Portfolio

While a diversified portfolio offers steady, long-term growth, the pursuit of beating the market often tempts traders/investors/market participants to deviate from this approach.

Any deviation nonetheless inherently involves additional risks.

The act of shifting weights in a beta portfolio – whether through leverage, overweighting, or shorting – introduces complexity to produce positive outcomes.

When these adjustments are based on consensus views (widely held beliefs about the market), they’re unlikely to yield significant excess returns, given that such views are often already priced into the market.

Understanding Market Calls and Consensus Views

What Constitutes a Market Call?

For a market call to have meaningful value, it must deviate from a traditional beta portfolio.

This could mean taking an overweight or underweight position in a specific asset class or using leverage to amplify returns.

Leverage changes returns, but simply owning more risk doesn’t change the risk-adjusted returns.

A call that doesn’t adjust the allocation of a portfolio is merely a reaffirmation of the basic beta approach and doesn’t offer additional value.

The Influence of Consensus on Market Returns

In trading, consensus refers to the general expectations of all investors about future market performance.

Because market prices reflect this broad consensus, a market call based on a consensus view is unlikely to yield additional returns.

Popular Beliefs Are Priced In

When traders act based on a popular belief – such as a seasonal “Santa Claus rally” or a “January effect” in the stock market – those expectations are likely already factored into current prices.

In market contexts, if something is widely known, it generally ceases to have value.

The Rewards of Beating the Market

Non-Consensus Calls and the Search for Alpha

Non-consensus market calls – i.e., the over/underweighting, shorting, something different from indexing – offer the potential for higher returns, often referred to as “alpha.”

Successful non-consensus calls can yield excess returns because they benefit from shifts in market sentiment as the broader market adjusts to new information.

For example, a trader who correctly predicts an unexpected market outcome, such as a significant political event favoring certain sectors, could realize profits as prices adjust to this unexpected news.

This potential reward is the primary motivator behind attempts to beat the market.

The Appeal of Alpha and Outperformance

Traders and investors seek alpha because it represents the potential to outperform a traditional beta portfolio.

Alpha generation is often seen as the ultimate achievement in active investing.

The appeal of alpha can drive traders/investors to put in significant effort and resources into researching and analyzing potential market calls that deviate from consensus.

The pursuit of alpha is nevertheless not straightforward and requires not only accurate predictions about future events but also an understanding of how other market participants are positioned.

The Risks of Trying to Beat the Market

The Challenge of Competing Against Skilled Investors

Beating the market isn’t merely a matter of predicting price movements; it involves outperforming countless other market participants, many of whom are professionals with advanced strategies and informational, analytical, and technological advantages at their disposal.

In making non-consensus calls, traders are essentially competing with other experts who may hold the opposite view.

There’s somebody on the other side of the trade and they’re probably relatively sophisticated.

This competition is fierce, and even experienced traders/investors face significant uncertainty about their ability to consistently make accurate calls.

Even people who have decades of experience and have some amount of measured outperformance on aggregate, it may partly be attributed to luck rather than pure skill.

We wrote about how long it takes to test trading strategies and understand the role of luck vs. skill in other articles.

Increased Risk and Portfolio Imbalance

Deviating from a beta portfolio to make a market call often results in an unbalanced portfolio, introducing additional risks.

For instance, if a trader decides to overweight equities due to expectations of a market rally, they must underweight another asset class to fund this adjustment. Or leverage it or deleverage another aspect of the portfolio.

This creates a portfolio with higher exposure to certain risks, making it more volatile than a balanced portfolio.

This imbalance requires careful risk management, as the trader may need to frequently adjust positions to maintain their desired risk level.

The Cost of Trading and Portfolio Adjustments

Market calls that involve shifts in asset allocation come with transaction costs, which can erode returns over time.

Each trade – whether to overweight or underweight a position – incurs fees, and the cumulative effect of these costs can diminish the benefits of trying to beat the market.

When factoring in these expenses, the net return on a portfolio that frequently shifts positions based on consensus views is often lower than the return on a stable beta portfolio.

Luck is Not an Edge

The Role of Luck in Market Success

Luck can have an outsized role, especially in the short run.

Even skilled traders/investors may experience success due to favorable market environments rather than unique insight. 

For individual traders, it can be especially challenging to differentiate between skill and luck when evaluating market performance.

For instance, in a separate article, we asked which of these strategies you might prefer.

A:

B:

Or…

C:

It looks like C, no?

It’s a trick question because they’re all the same strategy!

They’re simply flip-a-coin strategies where 1% of your account is used per trade per day.

It can be difficult to differentiate between luck and skill, especially over shorter time horizons.

The Danger of Overconfidence in Market Calls

Overconfidence can lead traders to make increasingly risky bets, assuming that past success is indicative of future performance. 

This mindset can be particularly dangerous when relying on non-consensus calls, as the complexity of predicting market shifts is amplified by the need to correctly anticipate both the future and the reaction of other traders. 

Overconfidence can lead to larger, more leveraged positions, increasing the risk of substantial losses if the call is incorrect.

Evaluating Investment Advice: Consensus vs. Non-Consensus Calls

Assessing the Value of Market Calls from Professionals

When seeking advice from your favorite financial personalities, evaluate whether a market call is based on a consensus or non-consensus view. 

Many professionals merely reiterate consensus views, as these calls are unlikely to provide any unique, added value. 

Look for those who have a strong track record of making accurate non-consensus calls and who understand the risks associated with their positions.

Recognizing the Limits of Non-Consensus Strategies

Even when considering out-of-consensus positions, be aware of the limitations and inherent risks. 

Most non-consensus calls fail, and only a small percentage succeed in delivering the desired alpha. 

Additionally, traders should evaluate whether the performance of a given strategy is uncorrelated to the broader market (beta) and thus truly offers diversification. 

If a strategy aligns too closely with market movements, it may fail to deliver the protective benefits associated with genuine diversification.

For example, if instead of simply going with a representative market index for your equity allocation (e.g., SPY, VTI) you choose to buy individual stocks, stocks mostly rise and fall together, so you have a lot of correlation with the index.

If you deviate, be sure there’s at least some strategic basis behind and not just a tactical one.

For instance, if income is more important to you than capital appreciation, you might choose a dividend-focused index instead of something that balances more between growth and value objectives.

Conclusion: The Balanced Approach to Building Wealth

The prospect of beating the market is alluring, but the associated risks and challenges make it a difficult goal to achieve consistently. 

The most reliable way to build wealth is through a diversified, long-only beta portfolio serves as a valuable reminder of the benefits of simplicity and stability in investing. 

For those who choose to venture beyond this approach, the pursuit of alpha should be approached with caution, realistic expectations, and a clear understanding of the potential costs.

In the end, the most sustainable way to grow wealth may be to prioritize a balanced portfolio driven by your personal savings rate, and focus on personal and professional growth. 

Trying to beat the market isn’t a path for everyone, and those who attempt it have to be prepared to face both the rewards and the risks that come with competing against the collective wisdom of the market.