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Actively-managed funds have, on average, lagged market returns and have even been criticised by esteemed investor Warren Buffett due to the high costs associated with them.
To this end, Warren Buffett has even said that the average investor would be better off investing in index funds, rather than putting it into actively-managed funds.
So, is it still possible for retail investors to outperform the stock market over the long term if they pick their own stocks?
Identifying the right company, then having patience
For a retail investor to achieve above-market returns, one needs to identify stocks that are trading at an attractive valuation. A stock could be cheap relative to its historical price-to-earnings ratio, its net asset value (NAV) or based on its future earnings potential.
This last point is usually the best option for a long-term investor as it could indicate strong growth on the horizon. Whichever is the case, what is important is for investors to be patient after the stock has been purchased.
Stocks usually do not increase in price overnight, rather they increase in price when many investors collectively feel that a company is trading at an attractive valuation. This could mean that a company’s stock price could move up in the next few months or after many years.
Either way, once an investor has determined that a company is trading at an attractive valuation, patience is required to let these stocks increase in price over time.
The underpriced nature of the stock and patience should thus allow one to be able to achieve market-beating returns over the long term.
Enjoy the volatility ride
Stock prices hardly every move up in a straight line, rather all the up and down movements in price a stock experiences is known as “volatility”.
Stocks experiencing big drawdowns is not an uncommon event. For example, it was reported by Marketwatch.com in 2018, that Apple shares fall by about 30% every 2.8 years on average.
Despite this staggering pullback every few years, its stock price has increased by 933%, from US$30.57 on 4 January 2010 to US$315.24 on 16 January 2020.
The above example shows that despite a company having a double-digit drawdown every few years, it was still able to achieve outstanding gains over a decade.
This means that if investors sold at every sign of trouble, they would never have managed to get the long-term returns that Apple afforded patient investors.
Foolish bottom line
Beating the stock market requires investors to find underpriced stocks that have good growth potential. Once they have done this, investors should sit back for a few years and enjoy the volatility ride.
By doing so they might be able to outperform the market through superior stock selection.
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The information provided is for general information purposes only and is not intended to be personalised investment or financial advice. Motley Fool Hong Kong contributor Saket Jhajharia doesn’t own shares in any companies mentioned.