What Does It Mean When People Say They "beat the Market"? How Do They Know They Have Done So?

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What does it mean when people say they "beat the market"? How do they know they have done so?

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"Beating the market" is a difficult phrase to analyze. It can be used to refer to two different situations:

1. An investor, portfolio manager, fund, or other investment specialist produces a better return than the market average. The market average can be calculated in many ways (some of which are shady and used to make it look like someone has exceeded market returns), but usually a benchmark like the S&P 500 or the Dow Jones Industrial Average index is a good representation of the market average. If your returns (which you can learn how to calculate here) exceed the percentage return of the chosen benchmark, you have beaten the market - congrats!

2. A company's earnings, sales or some other valuation metric is superior to that of other companies in its industry. How do you know when this happens? Well, if a company beats the market by a large amount, the financial news sources are usually pretty good at telling you. However, if you want to find out for yourself, you need to break out your calculator and request some information from the companies you want to measure. Many financial magazines do this sort of thing regularly for you - they'll have a section with a title like "Industry Leaders." We don't suggest you depend on magazines for your investment picks, but these publications may be a good place to start when looking for companies to research.

Indexers: A Free Ride on Market Efficiency

By Don Luskin

Special to TheStreet.com

4/30/01 10:14 AM ET

URL: http://www.thestreet.com/comment/openbook/1409370.html

To: Louis Rukeyser, "Wall $treet Week with Louis Rukeyser"

Dear Lou,

Last Friday evening, you inducted John C. Bogle, the founder of Vanguard Funds, into the "Wall $treet Week with Louis Rukeyser Hall of Fame."

You correctly credited Bogle with introducing "the first indexed mutual fund" at Vanguard in 1975. All too often, Bogle is credited too broadly with introducing the very first index fund. In reality, he was only the first to offer index funds directly to the general public in the form of mutual funds.

The idea of the index fund was born in academia. Many great minds contributed to the concept, but first among them are Harry M. Markowitz, Merton Miller and William F. Sharpe, who shared the 1990 Nobel Prize in economics for this work.

The first commercial index fund was introduced by Wells Fargo Bank in 1971, four years ahead of Vanguard, under the leadership of John McQuown. It was created for the Samsonite pension fund's investment portfolio, with an initial investment of only $5 million. Today, at least a trillion dollars are invested in index funds worldwide, probably twice that. Most of it that is managed by banks on behalf of pension funds, university endowments and charitable institutions. Mutual funds make up a trivial portion of worldwide index-fund investing.

I used to work at Wells Fargo, starting several years after McQuown and the first generation of indexers had already moved on to other things. Even then, it used to bug us to see Bogle take all the credit -- at least in the mind of the general public -- for inventing index funds. But at the end of the day, we were delighted to have him out there winning hearts and minds for us.

Lou, for Bogle, index funds fit into a larger crusade that you also celebrated on your show: the mission of reducing the costs of investing for the general public. Index funds naturally lower the costs of investing because they eliminate expensive investment managers and traders, and they cut transaction costs by reducing the volume of portfolio turnover.

This is important because costs are the single biggest reason that it's so difficult to "beat the market." If you define the market as a comprehensive index like the Wilshire Total Market Value Index, then investors -- on average -- will always underperform by the amount of their costs. The index has no costs whatsoever, but investors have management fees, commissions, research expenses, taxes and so on. The market is a closed system, in which the winners win at the expense of the losers -- but they both pay costs, so it's a negative-sum game. Costs are a leak in the bucket of performance.

Does that mean that it's impossible to beat the market? The most zealous advocates of indexing have claimed just that since 1971. But it isn't true.

It is possible to beat the market. But it's not possible for everyone to beat the market all at the same time. There have to be winners and losers (and both pay costs). So that means that it's very, very hard to beat the market. But not impossible.

Does this mean I'm saying that the market isn't efficient? Not at all. Beating the market is what makes it efficient! Beating the market means you have superior information, and you've taken wealth from people who have inferior information. In the process, your superior information gets impounded into market prices. And when academics talk about the efficient market, they simply mean that prices reflect all of the available information. Beating the market is the incentive system for getting that information into prices and making the market efficient.

Indexers are "free-riders" on the process of market efficiency. They rely on high-cost investors to go out there and take their chances, trying (and often failing) to beat the market, but in the process making market prices efficient. The indexers simply buy the whole market at those efficient prices and get all of the benefits of all those efforts and costs for next to nothing.

Hmmm ... if we investors who battle it out every day trying to beat the market are just keeping the market efficient for indexers, maybe it's we who ought to be honored on "Wall $treet Week" -- not Bogle!

 Don

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Beating the '05 Market

By Jim Jubak

MSN

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