Beat the Market

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Whether or not a trader can “beat the market” is the ultimate test of his abilities.

Successful individual traders use indexes to benchmark their own trading programs as a measure of their own trading prowess. Each trading program will have its own method of achieving success above and beyond what is seen in the overall market, but there are a few guidelines to help you beat a market index.

The reason indexes are used as the benchmark measurement of market success isn’t just because they’re “average” by definition; it’s also because their average-ness contains its own built-in loss preventer.

Consider the S&P 500 Index, for instance. Five hundred stocks is a lot of companies represented, and a very large degree of diversification. For any one stock that may be suffering its own idiosyncratic losses on any given day (CEO scandal, natural disaster, etc.), there is bound to be another stock that is having a uniquely successful day of gains (new product, M&A success, etc.). So the overall risk in a stock index is buffered and greatly reduced.

Most trading programs that fail to beat an index don’t fail because they couldn’t pick good stocks – they fail because they were too heavily exposed to the risk of a few bad stock picks.

To combat that risk, your trading program should learn from the indexes and do what they do: diversify to reduce your risk.

This can mean holding as many positions as possible, or making as many short-term trades as possible, to accumulate enough winners that will offset the losers’ losses. Diversification can also mean choosing a broad enough selection of many different types of trades, whose performance expectations aren’t correlated to each other, to hold at any one point in time.

This is the same concept as holding a large percentage of your trading capital in cash (which obviously isn’t correlated to the performance of an individual stock pick), or at least making sure each trade you make only places a certain amount of your capital at risk.

With those guidelines in mind, you can get to the business of doing what your trading program is supposed to do: pick winning investments. You will need to have some “edge” to improve your chances of doing better than the rest of the market, whether that edge is specialized knowledge in a certain industry, or just excellent technical trading and trading programming skills.

But again, it’s equally important if not more so, for you to avoid poor trading choices than it is for you to make good ones. A trading program that invested in all 500 of the same stocks in the S&P 500 could beat the index just by identifying the stocks that either

a) were anticipated to do poorly for some reason, or

b) just placed the trading portfolio at too much risk.

Protecting your good trades from the depressing effects of a few bad trades is a key part of risk management, a key part of beating an index, and therefore a critical part of being a successful trader.

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