How to Beat the Market

. July 20, 2011
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When we first discussed how to fund your dream, we assumed a 7% return after adjusting for inflation. If you make 11% before inflation and your money loses 4% of its value per year, you're really making 7%.

"But doesn't an 11% return beat the market?" you ask. "I thought that was impossible."

To answer that question, let me tell you a story.

The Random-Walk Model

Picture yourself in a boat on a river. The boat slowly moves down the river, but small waves also strike it from every side. The movement down the river is called the boat's drift. The buffeting from the waves is called volatility.

This is the picture that most money managers use to model the stock market. In their minds, the market always drifts upward at the same speed, and the waves' movement is completely random. This is called the random-walk model.

In this model, the stock market is supposed to move like drunk man who's slowly making his way down the street.  His steps are mostly random in the short term but have a constant drift in the long term.

Now imagine a race with hundreds of boats floating down a very wide river. If the water drifts at a constant speed and the waves are completely random, the best thing you can do is bet on every single boat.

That's why your money manager tells you that beating the market is impossible over the long term. The hundreds of boats are the market. If stocks, like boats, simply drift in the long term and move randomly in the short term, picking winning stocks is a madman's dream.


(Un)fortunately, this picture is not real for either the river or the stock market. If you've ever gone kayaking, you know that a river's speed isn't constant. There are places where the speed changes due to the shape of the banks and the river's width and depth. These changes in speed depend on the river's shape, and they're not random.

Fast water tends to follow fast water, and slow water tends to follow slow water. In stock market terms, this is called momentum. If you're trying to win a boat race, you want to be in the fast water. And if you're trying to win in the stock market, momentum matters.

Evidence of Momentum1

Here's some evidence for the existence of momentum. Non-geeks, click the links at your own peril. You have been warned.
  • "Long-term moving average crossovers [a momentum strategy] haven’t been useful for generating outsized returns, but they have done a good job protecting investors from protracted downturns." (MarketSci)

  • "Moving average crossovers have been more effective over the last decade than at any point in the last 80+ years." (MarketSci)

  • Why every trader needs to watch the 200-day moving average. (TradingMarkets)

  • Trend-trading the Nasdaq 100. (Catallactic Analysis)

  • "With no data mining or systems optimization, such that anyone analyzing the same S&P500 database would have made the same investment decisions, this basic trend-following system beats the markets." (AdvisorPerspectives)

  • "Applied to the S&P 500 index over 1900-2005, the model produces a 10.66% compound annual growth rate, compared to 9.75% for buy-and-hold. The timing model is less volatile than buy-and-hold. The model underperforms the index in about 40% of all years but avoids the worst bear markets.... Over the period 1972-2005, the timing model improves raw (risk-adjusted) returns for about 70% (90%) of 20 other indexes across asset classes." (CXO Advisory)

  • "A non-discretionary, trend-following model acts as a risk-reduction technique with no adverse impact on return. When tested on various markets, risk-adjusted returns were almost universally improved.... In addition, the investor would have also been able to sidestep many of the protracted bear markets in various asset classes. Avoiding these massive losses would have resulted in equity-like returns with bond-like volatility and drawdown." (Mebane Faber)
Besides having momentum, real rivers sometimes make sudden waves that are much larger than normal. These waves happen in the stock market too and are called fat tails.

Traditional money managers aren't prepared for this because their models assume that fat tails can't exist. If you're interested, you can read more about fat tails here.

    How to Trade Momentum

    The good news is that you don't have to be a genius to make money. You do have to think differently. If you let go of the assumption that beating the market is impossible, you can trade momentum.

    Remember that momentum is the tendency of a market to keep moving once it's gotten started. A market that's moving up tends to keep gaining. One that's falling tends to drop further.

    One way to use momentum is to sell out of markets that start falling to avoid further losses. Once the momentum has shifted back to an upward direction, we buy back in. The math involved in doing this only takes a few minutes a month.

    I mentioned a book called The Ivy Portfolio when we discussed how to fund your dream. The book's strategy uses momentum to avoid large stock market losses. It also looks how the Harvard and Yale endowments diversify their investments. The combination of momentum and diversification leads to the market-beating returns you asked about in the beginning of this article.

    The best way to get started is to read The Ivy Portfolio. The strategy is laid out pretty clearly there. There are also summaries about the book here and here, with the author's original paper here. This article shows how the strategy avoided the housing crash in 2008. This page has the 10-month moving average that's used in The Ivy Portfolio.

    But Wait... There's More!

    In my own trading, I rely on more than just momentum. If you'd like to trade multiple strategies like I do, read the Resource page on this site to get started. Just know that it will take you years to learn more than one strategy. You have to make it a second job.

    Out of all the strategies I know, momentum is the simplest to apply. This is good for someone who wants to be an investor, not a trader.

    My guess is that you want to spend most of your time earning more, spending less, and preparing for your dream of ministry. So get to it!

      [1] An economist who read this post commented that evidence of momentum (not evidence of fat tails) is the correct way to address weaknesses in the random-walk model. I've added this extra section to the post as a result. This post used to have a section about fat tails and money management. I modified the section to address the distinction between Modern Portfolio Theory and random-walk as a broader hypothesis and then moved it to its own post.


      Kelly said...

      This is great information, Darren!

      Are there any "success" stories floating around the internet of people using this momentum strategy?

      ReformedTrader said...


      Thanks for the feedback! Michael Covel wrote a book called "Trend Following" that's a good collection of those stories. It's pretty light on statistics, which is a weakness in my opinion, but a good read.

      Kelly said...

      Thanks! We came into a bit of money when we sold the house, and are trying to decide what to do with it.

      ReformedTrader said...

      The Ivy Portfolio is a good place to start. It's more data-driven than most other books but is still pretty readable.