How To Outperform The Market

All investors must re-evaluate and refine their investing styles and strategies from time to time. As we gain investing experience and knowledge, our view of the market is likely to change and may broaden how we envision our financial goals.

Those who want to try to outperform the market—that is, realize returns greater than the market average—might consider an active trading strategy, even if only for a portion of their portfolio.

What Is Active Trading?

The best way to understand active trading is to differentiate it from buy-and-hold investing, which is based on the belief that a good investment will be profitable in the long term. This means ignoring day-to-day market fluctuations. Using a buy-and-hold strategy, this kind of investor is indifferent to the short-term for two reasons: first, because one believes any momentary effects of short-term movements really are minor compared to the long-term average, and second, because short-term movements are nearly impossible to exactly predict.

An active trader, on the other hand, isn't keen on exposing investments to the effect of short-term losses or missing the opportunity of short-term gains. It's not surprising then, that active traders see an average long-term return not as an insurmountable standard but as a run-of-the-mill expectation. To exceed the standard (or outperform the market), the trader realizes that they must look for the profit potential in the market's temporary trends, which means trying to perceive a trend as it begins and predict where it will go in the near future.

Below is a chart that demonstrates the difference between the long- and short-term movements of the market. Note that even though the security moves upward over time, it experiences many smaller trends in both directions along the way.

Focus on Short-Term Performance

Traders are "active" because for them the importance of the market's short-term activity is magnified—these market movements offer opportunity for accelerated capital gains. A trader's style determines the time frame within which trends are identified. Some look for trends within a span of a few months, some within a few weeks and some within a few hours. Since a shorter period will see more definitive market movements, a trader analyzing a shorter time frame will also be more active, executing more trades.

A greater number of trades doesn't necessarily equal greater profits. Outperforming the market doesn't mean maximizing your activity, but maximizing your opportunities with a strategy. An active trader will strive to buy and sell (or vice versa in the case of shorting) at the two extremes of a trend within a given time frame. When buying a stock, a trader may try to buy it at the lowest point possible (or an upwards turning point, otherwise known as a bottom), and then sell it when there are signs that it has hit a high point. These signs are generally observed by means of technical analysis tools, which we discuss below. The more the trader strives to buy and sell at the extremes, the more aggressive (and risky) their strategy.

Maximizing returns or outperforming the market isn't just about reaping profits, it's also about avoiding losses. In other words, the trader will keep an eye out for any signs that the security is about to take a surprising turn in an undesirable direction. When these signs occur, the trader knows that it is time to exit the investment and seek profits elsewhere.

A long-term trader, on the other hand, stays invested in the security if there remains confidence in its prospective value, even though it may be experiencing a downward shift—the buy and hold investor must tolerate some losses that the trader believes are possible to avoid.

Use Technical Analysis

You need particular analytical techniques and tools to determine when a trend starts and when it will likely come to an end. Technical analysis specializes in interpreting price trends, identifying the best time to buy and sell a security with the use of charts. Unlike fundamental analysis, technical analysis sees price as an all-important factor that tells the direction a security will take in the short term.

Here are three principles of technical analysis:

• For the most part, the current price of a stock already reflects the forces influencing it—such as political, economic and social changes—as well as people's perception of these events.
• Prices tend to move in trends.
• History repeats itself.

From these three principles emerges a complicated discipline that designs special indicators to help the trader determine what will happen in the future. Indicators are ways in which price data is processed (usually by means of a calculation) in order to clarify price patterns, which become apparent when the results of the indicator's calculation are plotted on a chart. Displayed together with plotted historical prices, these indicators can help the trader discern trend lines and analyze them, reading signals emitted by the indicator in order to choose entry into or exit from the trade. Some examples of the many different types of indicators are moving averages, relative strength and oscillators.

Fundamental analysis can be used to trade, but most traders are well trained and experienced in the techniques of charting and technical analysis. It is a blend of science and art that requires patience and dedication. Because timing is of the utmost importance in active trading, efficiency in technical analysis is a great determiner of success.

Leveraged Trading

The short term approach of investing offers opportunities to realize capital gains not only by means of trend analysis, but also through short-term investing devices that amplify potential gains given the amount invested. One of these techniques is leveraging, which is often implemented by something called margin.

Margin is simply the use of borrowed money to make a trade. Say you had $5,000 to invest: you could, instead of simply investing this amount, open a margin account and receive an additional, say, $5,000 to invest. This would give you a total of $10,000 with which to make a trade. So, if you invested in a stock that returned 25 percent, your $10,000 investment turns into $12,500. Now, when you pay back the original $5,000, you'd be left with $7,500 (we'll assume interest charges are zero), giving you a $2,500 profit or a return of 50 percent. Had you invested only $5,000, your profit would've been only $1,250. In other words, margin doubled your return.

However, as the upside potential is exacerbated, so is the downside risk. If the above investment instead experienced a 25 percent decline, you would have suffered a loss of 50 percent, and if the investment experienced a 50 percent decline, you would've lost 100 percent.

You may have already guessed that, with leverage, a trader can lose more than the initial investment! As such, it is a trading tool that should be used only by experienced traders who are skilled at the art of timing entry into and exit from investments. Also, since margin is borrowed money, the less time you take to pay it back, the less interest you pay on it. If you take a long time to try to reap profits from a trade, the cost of margin can eat into your overall return.

The Risks of Active Trading

Active trading offers the enticing potential of above-average returns, but like almost anything else that's enticing, it cannot be achieved successfully without costs and risks.

The shorter time frame to which traders devote themselves offers a vast potential, but since the market can move fast, the trader must know how to read it and then react. Without skill in discerning signals and timing entries and exits, the trader may not only miss opportunities but also suffer the blow of rapid losses—especially if, as we explained above, the trader is riding on high leverage. Thus, learning to trade is both time consuming and expensive. Any person thinking of becoming an active trader should take this into account.

Also, the higher frequency of transactions of active trading doesn't come for free: brokerage commissions are placed on every trade. Since these commissions are an expense, they eat into the trader's return. Because every trade costs money, a trader must be confident in making decisions: to achieve profits, the return of a trade must be well above the commission. If a trader is not sure of what to do and ends up trading more frequently because of blunders, the brokerage costs will add up on top of any losses.

Finally, because securities are being entered and exited so often, the active trader will have to pay taxes on any capital gains realized every year. This could differ from a more passive investor who holds investments for numerous years and does not pay capital gains tax on a yearly basis. Capital gains tax expense must also be factored in when an active trader is calculating overall return.

The Bottom Line

As you gain more education and experience as an investor, you may become curious about the different ways to reach returns. It is important to be willing to learn about different strategies and approaches, but it is equally important to know what suits your personality, skills and risk tolerance.

You may have guessed that active trading is best suited to those who are committed to taking control over their portfolio and pursuing their goals quickly and aggressively. All of this requires a willingness to not only take risks, but also keep up skills and efficiency. If this sounds like you, it may be time to start learning more!