In an earlier post, I explained how index funds work – essentially, they buy all of the largest funds on a market index proportionally, so that the investment moves the same way as the index it tracks. Today, I’m going to explain how you can actually beat the market by buying index funds.

A Portfolio of Index Funds

To start off, this strategy requires a mix of at least two or more different types of index funds in your portfolio – specifically, they need to be funds that won’t move in the same direction at the same pace. The TSX and the S&P 500, for example, move very similarly to one another – you’re not really looking for that.

Instead, you’re better off with at least one stock index fund (I like the TSX) and one bond index fund, because they tend to behave differently in the same environment. In other words, when one does really well, the other tends to lag, and vice versa.

So why would you ever want this? Well, stay tuned to find out.

Buy Low, Sell High

You’ve heard this adage before, and for good reason – it is literally the most basic and foundational advice for how to succeed in investing. Here’s how it applies to a portfolio of index funds.

Say you want to maintain a fairly average mix of stocks and bonds – we’ll go with 70% stock index and 30% bond index. Over time, these investments will perform differently, and that 70/30 balance will get out of whack. Maybe your stock index performs better than your bond index, and all of a sudden your money is sitting at an 80/20 split between stocks and bonds.

When that happens, you can make some extra money by selling off just enough of the better-performing investment that you can get back to your target investment mix; in this case, it’s 70/30.

By doing that, you’ll be buying low and selling high at the same time: you’re selling off your “high” asset to pay for your “low” asset.

Let’s look at some numbers.

Ok, so say you have $10,000 to start: $7,000 in a stock index and $3,000 in a bond index.

Then the market rages forward. Your $7,000 turns into $10,000, and your bond index stays right where it is at $3,000. Now you have a total of $13,000, for a 30% return.

There’s just one problem: your mix has changed. Instead of 70/30, you’re now at 77/23 in favour of stocks.

To get back to your 70/30 mix, you’ll have to sell off $900 of your stock index, and invest that money into your bond index. Then you’ll be at $9,100 in stocks, and $3,900 in bonds, for a perfect 70/30 split.

Now let’s say that the stock market takes a turn for a worse, and actually loses 30%, while your bonds stay unchanged. In this case, your stocks would be worth $6,370, while your bonds would still be worth $3,900, making your total investment worth $10,270.

Wait a sec.

Overall, the stock market actually declined 9%, yet you still have more money in the bank than you started with – you’re up 2.7% in the same tiemframe. How is that possible?

It’s possible because you bought low and sold high. You sold some of your stocks when the market was good, meaning you had less to lose when the market went sour. If we were to continue the example, at that point your split would be 62/38 in favour of stocks, which is now too low. So you’d sell off $821 of your bonds and put them back into stocks to get back to your 70/30 split once again.

Each time you do this, you’re buying low and selling high. And though this is an extreme example, by doing this consistently – even once or twice a year – you can actually beat the market by enough to offset the management expenses on your index funds, which means you truly beat the market.

On average, I’ve beaten the market by around 1-2% each year by employing this strategy, which makes a huge difference to the size of your nest egg over the long term!

Wrapping it Up

There are people far smarter than I am who have written extensively about this topic as well – in fact, Dan over at the Canadian Couch Potato blog has built an entire website and business around this strategy. I highly recommend you check it out to learn more about this concept.

Hopefully though, my two posts about index investing help to give you an idea of just how powerful these tools can be when you put them to work for you in a thoughtful and deliberate way. Index funds are my road to retirement, and they can be yours too!