3 Secrets to Outperforming the S&P 500

Famously successful investor Warren Buffett has said that most investors will be best served over the long term by putting their dollars into a fund that tracks the S&P 500 index. With a 302% total return over the last 10 years and a nearly 2,000% total return over the last three decades, it’s not surprising that the Oracle of Omaha is touting the wisdom of putting your money in a diversified fund that tracks the popular benchmark index.

On the other hand, investors who are willing to take on more risk may be able to improve their overall performance and achieve better returns than the market at large. With that in mind, a panel of Motley Fool contributors have identified three ways that investors can put themselves in position to outperform the S&P 500 index. Read on to see why they think that these guidelines can help boost your total returns.

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Win big by thinking small

Keith Noonan: As the name suggests, the S&P 500 index includes the stocks of 500 of the largest U.S.-based companies. While some massive companies including Apple and Amazon have managed to defy gravity and continue growing sales at a rapid clip, smaller businesses often have an easier time delivering relative growth.

If a company is already doing $40 billion in annual revenue, doubling its sales may prove to be a difficult feat — or at least one that takes quite a while. Meanwhile, there are plenty of young companies that are doubling their sales within a few years’ time — or even quicker, and signs of rapid expansion often translate to strong stock performance.

Of course, investors also have to take on some extra risk when backing small companies. They’re at earlier growth stages and typically have less defensive fortitude and ability to weather unexpected challenges. The upside is that backing a single small company that goes on to be enormously successful over the long term can more than make up for stocks in your portfolio that didn’t live up to expectations.

Imagine having bought Shopify stock in June 2015, when the company’s market capitalization was still in the $2 billion range. Today, the e-commerce services company has a market cap of roughly $182.5 billion. That kind of growth would have had a defining impact on your portfolio performance.

So, how can investors find small-cap plays that go on to deliver big returns? Rather than looking for volatile stocks that could see major swings in the near term, it pays to focus on strong businesses that look poised to go the distance. It’s easier said than done, but it pays to prioritize finding companies with competitive advantages that are operating in industries with favorable long-term growth outlooks. Not every one of your small-cap growth plays will pan out, but finding even a handful of big winners can transform your portfolio performance.

If it seems too good to be true…

James Brumley: Having been in this business for 20 years, I’ve seen it all. The funny thing is, there’s not a lot of differentiation within this “all.” The same basic themes — and subsequent lessons — are simply recycled. And one of the most common themes that ends up hurting investors more than helping them is buying into gimmicks that feel empowering at the time, but are ultimately short-sighted.

Yes, meme stocks like AMC Entertainment (NYSE: AMC) and BlackBerry (NYSE: BB) are examples of this phenomenon. There’s certainly something thrilling about sticking it to a hedge fund with a highly shorted stock like AMC. Sparking a short squeeze that sends it upward again is the pinnacle of paybacks. The end result of such a rally, however, is that a bunch of short-term-minded traders now own an overvalued stock that’s vulnerable to a similarly big wave of profit-taking.

Here’s the problem: The traders who coordinated the short squeeze aren’t going to coordinate the orderly and equitable selling of the stock. They’re going to quietly lock in their gains first, sparking what’s likely to then turn into a wave of profit-taking, dragging shares of AMC well below their recent peak price in the process.

And that’s just one example of a misguided idea. Another example is falling for well-hyped stories that never had a chance of actually panning out. Theranos, WeWork (which fortunately never got a chance to go public), Groupon (NASDAQ: GRPN), and Blue Apron (NYSE: APRN) come to mind.

I know it’s boring, but a simple, straightforward portfolio of proven companies held for the long haul gives you much better odds of beating the market. The easy money and get-rich-quick strategies usually just end up making someone else rich — at your expense.

Acknowledging the psychological battle of investing

Daniel Foelber: New investors may roll their eyes when they hear that the majority of professional money managers fail to beat their benchmark. But the truth is, beating the market is difficult, especially if you’re trying to do it over shorter periods of time. Anything can happen in a month or a year. Trying to go toe-to-toe with Mr. Market’s ebbs and flows is usually how folks get in trouble. Scrambling to catch what’s working one year then shifting to something entirely different on a whim is a great way to lose your shirt.

In many ways, actively trying to beat the market by investing in hard-to-understand and confusing companies is one of the worst ways to beat the market. That’s because two of the biggest mistakes investors can make are selling a paradigm-shifting growth story too soon or selling a good company during a stock market crash. Trust me, I’ve done both.

If you talk to investors who have been at it a while, they’ll usually say their worst mistake was selling a company like Tesla, Target, or Starbucks too soon. We are all human, and the psychological battle of investing can oftentimes be harder than the security analysis itself. Having a firm grasp on what you own offers a better chance to avoid the noise and stay focused on the long-term thesis of a company.

You’ve probably heard that the S&P 500 has averaged around an 8% return over the long term. To illustrate just how powerful that is, consider the Rule of 72. It basically involves taking the number 72 and dividing it by the annual return to get the number of years needed to double your money. For an 8% average return, that would mean an investor doubles their money every nine years. Do that for a few decades while saving a decent percentage of your income and you’re almost guaranteed to be a millionaire before you know it.

The U.S. stock market is full of bad companies, shady short-sellers, Reddit ruffians, and all kinds of other mischiefs. But warts and all, it’s a game that’s rigged in your favor. Combating the psychological challenges of investing by understanding what you own and why you own it can help provide the tools you’ll need to make better decisions in the heat of battle.

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John Mackey, CEO of Whole Foods Market, an Amazon subsidiary, is a member of The Motley Fool’s board of directors. Daniel Foelber has the following options: long August 2021 $120 calls on Apple, long July 2021 $50 puts on AMC Entertainment Holdings, short August 2021 $125 calls on Apple, and short July 2021 $49 puts on AMC Entertainment Holdings. James Brumley has no position in any of the stocks mentioned. Keith Noonan has no position in any of the stocks mentioned. The Motley Fool owns shares of and recommends Amazon, Apple, Shopify, Starbucks, and Tesla. The Motley Fool recommends BlackBerry and recommends the following options: long January 2022 $1,920 calls on Amazon, long January 2023 $1,140 calls on Shopify, long March 2023 $120 calls on Apple, short January 2022 $1,940 calls on Amazon, short January 2023 $1,160 calls on Shopify, short July 2021 $120 calls on Starbucks, and short March 2023 $130 calls on Apple. The Motley Fool has a disclosure policy.

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