The One Rule that Explains Trading Success

It is hard to “beat the market.”  Not only does the evidence indicate that few investors, if any, are able to consistently do so, even investors that subscribe to indexing underperform the index.  Why is this?  Why is it so hard to outperform?  What is so unique about indexing that makes it difficult to beat?

We believe the answer is counter-intuitive and not widely appreciated.

There are always new trades to invest in.  Mideast turmoil has you nervous?  Trade oil.  Think the Fed is creating inflation?  Trade bonds.  The list is endless.  There is no shortage of products, funds, ETFs and alternatives from which to choose.  There are CTAs and hedge funds catering to any investment whim.  But are any of us able to pick the right strategies and profit from them over and over?  It gets even harder when we have to pick a manager to do it for us.

Those that promote indexing seem to do so with the same vigor as those promoting the endless stream of trade ideas.  From brokers promoting newfangled options strategies to gurus selling the latest beat-the-market schemes, all, including investors in index funds, seem to consistently do worse over time than a simple market index.

While the evidence is compelling, there ARE managers, strategies and businesses that consistently do better than an index.  They are extremely hard to find.  Once found, investors in these businesses can STILL do worse, however.

Why is this?

Why do investors, when given the opportunity to invest in an index fund or even a proven business that outperforms an index fund, STILL underperform?

Some claim it is due to fees, fund expenses or that markets are “efficient,” and fundamentally unbeatable.

The real answer is DISCIPLINE.

Discipline is the key one-word explanation for success in almost any field.  If you’re not disciplined, you’re unlikely to succeed—in doing scientific research, to daily exercise, to running a profitable business, to investing.  The common theme to success is plainly discipline.

Having a disciplined process and approach is critical.  Without them, one may show random short-term success but inevitably succumb to failure.

Beating the index is hard, not because of all those academic theorems.  It is hard because index investing itself is a disciplined strategy.

What is indexing?  It is a rigorous quantitative strategy where stocks are chosen in a clearly systematic process, and repeated algorithmically over and over.  There is no emotion, no second guessing and no “trading off the news.”  The rules are simple.  The implementation is simple.  It is a disciplined quantitative strategy.  The hard part is sticking to it.

It is hard to beat any systematic strategy that has an edge.  Indexing is hard to beat for the same reason it is hard to beat a computer at many tasks.  But indexing, like many systematic strategies, only work if you follow it.  If you “override” or “second guess” the index, you’re no longer disciplined and likely to underperform.  Most investors underperform the index because most are not disciplined.

If you’re looking to beat the market, first make sure that you can match the market.  This means following the systematic and disciplined trading strategy known as “indexing.”  Only then, if you have the discipline to do so, finding other automated investment programs becomes much easier.   Zem Sternberg