When I buy shares of VTI (Vanguard’s Total Stock Market Index Fund), I get a tiny slice of almost every publicly traded company in the United States. I own a piece of the entire stock market.
Historically, this type of low-cost index fund has delivered an average return of 10-11% per year. That’s enough to double my money every 7 years on average, or to turn a single foregone new car purchase into a million dollars in 35 years*, without lifting a finger.
Some fans of index funds insist that there’s no way to beat them. Active mutual fund managers brag that they can easily outperform the S&P 500 and other stock indexes (for a fee 😉). So who’s right?
Well, the truth is somewhere in between. Let’s look at four ways to beat index funds that actually work over the long run — and the disadvantages of each one.
Note: We are not financial advisors. We’re just a couple of bloggers honestly sharing what has worked for us. This article contains personal opinions for your consideration, not professional financial advice. Check out our Disclosures page for more information.
1. Beating the Market with Higher-Risk Investments
If someone offers you a low-risk, high-return investment, that person is probably a liar (and/or an insurance salesman).
Risk and reward are intrinsically linked because of something called the efficient market hypothesis. It basically says that financial markets are super competitive, so the moment that any abnormally amazing opportunity pops up, droves of investors (or Wall Street computer algorithms) will flock to take advantage of it, and that opportunity will instantly disappear.
To understand this better, imagine if there were only two investments available in the whole world:
- Investment A: Costs $10 per share today and is guaranteed to be worth $20 in 5 years (low risk, high reward).
- Investment B: Costs $10 per share today, and in 5 years, you get to flip a coin to determine whether it’s worth $7 or $20 (high risk, high potential reward).
Which would you choose?
You shouldn’t even have to stop to think about it. You’d buy Investment A immediately. And so would everyone else on planet Earth. In fact, Investment A would be purchased so quickly by so many people that its current price would skyrocket beyond $10 until it was about equally as attractive as Investment B (at its new price).
This is exactly what happens in real life: Lower-risk investments are bid up to higher prices, which tends to depress their future returns. Higher-risk investments may be less expensive today, which provides more room for potential growth in the future. In other words, risk is automatically “priced in” to all assets.
There’s good news though: If you’re willing to take extra risk, you can give yourself a chance at beating broad index funds! There are a lot of ways to do this (some good, some bad), but I’ll focus on two that at least have a reasonable chance of working.
The first strategy is to shift from total market index funds into higher-risk versions. For example, you could trade a portion of your position in VTI (or an S&P 500 index fund) for VB (a small-cap US stock market index fund) instead. Historical data shows that smaller companies often beat the market by a little bit over the long run — with more volatility and risk along the way.
Similar swaps might include:
- Trading some VXUS (our favorite total international stock market index fund) for VSS (a small-cap international stock market index fund) instead.
- Trading some BND (our favorite total US bond market index fund) for JNK (a high-yield “junk bond” index fund) instead.
But these holdings aren’t fundamentally “better” than total market index funds; they’re just a bit riskier, and as a result, they have some chance at higher long-term performance. It’s a tradeoff.
If you still want to take more risk, another strategy that can boost returns is to use leverage in your investment portfolio**. Using leverage just means taking out a loan and buying investments with the proceeds (in other words, buying investments with other people’s money).
Leverage multiplies investment returns. For example, if you invested $100k into an S&P 500 index fund and earned 10%, you’d make $10k in profit. But if you borrowed another $100k to invest, you’d earn twice as much (minus the interest on the loan).
Real estate investors use mortgages to achieve this. For example, by putting 20% down on a series of mortgages, you could buy a million dollars worth of rental properties with only $200,000 of your own capital.
Here’s the problem: Leverage multiplies returns in both directions. When your investments are making money, it can feel great. But when bad times come, and the market takes a dip, your losses will be amplified, too. Depending on how much leverage you’re using, a market crash can actually bankrupt you!
Personally, we’ve never made use of leverage in our own portfolio — it’s just too risky for us.
2. Taking Advantage of Inefficient Markets
The efficient market hypothesis applies to stocks and bonds because they’re traded in highly competitive, purely financial, global markets. That makes it almost impossible to gain an advantage over other investors (even for experts), and it’s also why buy-and-hold index funds are generally the best option in those arenas.
But that’s not true of every investment.
Imagine finding a beautiful house listed for sale by owner in a rural part of Montana. It’s been on the market for a month, and you’re only the second person to actually check it out. The owner of the property is moving to a beach house across the country for retirement next month and really wants to use cash from the home sale on a yacht.
As a potential buyer, you have several advantages going for you:
- There’s practically no competition from other bidders.
- The owner is under pressure to sell within a specific timeframe.
- Personal factors (like that sweet, sweet yacht) are at play in the seller’s mind, which might cloud their judgment.
- The property you’re bidding on is non-fungible, and thus difficult to price accurately.
All of these things increase your chances of successfully landing an amazing deal and scoring the house at a huge discount to its fair market value. And none of these advantages would be possible in a more competitive, more efficient marketplace — like the public stock market.
Lots of relatively inefficient markets still exist in the world, spanning everything from local real estate to rare trading cards to used furniture. As a general rule, the fewer financially-minded eyeballs are on a marketplace, the more opportunity there is to make favorable trades there.
But there are some limitations and disadvantages to this strategy, too.
For one thing, you need to know a lot about a market to really eke out an edge there. Your goal is to snag mispriced items, so you need to be really good at correctly pricing those things, without the help of data from thousands of other bidders and sellers.
And by trading in markets with only a small number of participants, you’re exposing yourself to liquidity risk: You might not be able to find buyers for the stuff you’re eventually gonna try to sell — at least not without some serious patience. It’s not as easy as just clicking the “sell” button on a brokerage website.
3. Making Use of Government Programs
Some investment opportunities exist entirely outside of the free market, making them immune to the theory of efficient markets.
For example, US savings bonds can’t be sold by investors at all. They must be purchased (and later redeemed) directly with the US Treasury. Because of this, their value is stable, relatively predictable…and sometimes, exploitable.
For example, a Series EE Savings Bond is guaranteed to double in value over a 20-year holding period, regardless of its interest rate. That implies a 3.5% annualized return if held to maturity. Normally, 3.5% wouldn’t be very exciting, but over the past 12 months (4/2021 – 4/2022), the highest guaranteed 20-year bond yield available in the open market has fluctuated between 1.7% and 3.1%***.
Since savings bonds can’t be traded on the open market, index funds are unable to hold them. They contain ordinary Treasury Bonds instead. That means the very best bond market index funds have been forced to buy technically inferior 20-year Treasury Bonds recently (assuming they intend to hold them to maturity).
An even more provocative example is the Series I Savings Bond (aka “I Bond”), whose guaranteed yield is linked to recent inflation. Since we’ve seen historically high inflation lately, the yield on these bonds is set to jump up to 9.6% in May 2022 (temporarily). That’s dramatically better than any other low-risk investment in the market today. In fact, Series I Savings Bonds bought right now (April 2022) are very likely to outperform total bond market index funds over the next 12 months.
Other examples of government-manufactured opportunities that can boost your effective investment returns include tax-sheltered accounts (like IRAs and HSAs) and subsidies on certain types of purchases (like electric vehicle tax credits and health insurance premium tax credits).
The main drawback to government investment programs is that they’re usually temporary and/or very limited in scope. For example, you can only invest $10,000 per year in I Bonds through Treasury Direct, and there are annual contribution limits on tax-advantaged accounts like IRAs and HSAs, too.
4. Investing in Your Own Business
Another way of beating the market is to invest in your own business instead of the publicly-traded companies found in stock index funds. Teaming your money up with some hard work allows you to build “sweat equity.”
My 18-year-old brother is an auto mechanic. Just last year, he bought a 2007 Dodge Charger with 175k miles and a busted radiator for $2,000. Fixing it up cost him another $300. That $2,300 investment plus about 8 hours of his time led him to resell the car for $6,200 inside of 2 weeks. He definitely beat the S&P 500 with that money.
In a similar vein, my dad and his wife recently bought a beach condo that needed some love. They put in work to make it look beautiful, and now they serve actively as Airbnb hosts with the hope of outperforming more passive rental properties (or REIT index funds) over the long run.
Pouring money into your own business puts you in the driver’s seat of your investment, and a lot of times, you can crush the returns of the stock market by doing it yourself. But it can be a little riskier, and the most obvious drawback is that it’s a lot of work!
The Worst Ways of Beating the Market
We’ve clearly shown that outperforming index funds is possible. But, it’s no free lunch. If someone tells you they have a simple and effortless way to consistently beat the market without additional risk, restrictions, or effort — run away.
Here are some of the worst (and most popular) ways of supposedly beating the market:
- Actively trading securities – When an inexperienced investor hits the jackpot on an individual stock, options contract, or crypto trade, it makes them feel like a genius. But it’s almost impossible to consistently outperform other speculators in an efficient marketplace. If you’ve done well with stock picking or day trading so far, congratulations. You’re in the minority. But now is a great time to take your money and leave the casino!
- Paying a mutual fund manager – High-fee, actively managed mutual funds really do outperform indexes like the S&P 500 occasionally, but it’s impossible to tell which ones will do so in the future. Looking at past performance doesn’t work because of survivorship bias, and on average, active mutual funds underperform comparable index funds by an amount roughly equal to their fees.
- Buying life insurance – If you need financial protection for your dependents, a term life insurance policy might make sense. But any life insurance policy that touts itself as an investment (like “whole life” or “indexed universal life”) is bad news. Most insurance companies just invest your money the same way you could, and then they skim off some profits for themselves. Their marketing materials are often full of half-truths to make you believe otherwise.
If you really want to consistently beat the market with your money, you’ll need to accept more risk or put in some hard work. There’s just no way around that.
But it’s also worth noting that you don’t need to beat the market at all. In general, decreasing your expenses is more important than getting higher investment returns, and you can save enough to retire in as little as 10 years by just working a regular job and investing passively through total market index funds.
There are definitely ways to beat the market, but personally, we’ll probably keep index funding our way to a lifetime of freedom and leisure instead. It’s just easier.
* Assumes a $32k new car purchase price invested in a stock market index fund to earn 10.5% annually for 35 years. This average return is based on a long track record of historical data, but it is not guaranteed. Investing in the stock market involves risk.
** If you own stocks and have a mortgage on your home at the same time, then you’re already using leverage (maybe without even realizing it!). To de-leverage, you could always sell your stocks and use that money to pay off your loan. Doing so would reduce the risk in your portfolio, but it would also probably reduce your long-term returns — a risk-reward tradeoff like any other.
*** This point is mostly academic: Government-priced Series EE Savings Bonds are technically superior to market-priced 20-year Treasury Bonds when interest rates are at very low levels. But EE Bonds still aren’t particularly exciting to us, personally, and we’re not suggesting that anyone should rush out and buy them.