How to Consistently Beat the S&P 500 (Pros Only)

Leverage, Concentration, and/or Shorting

Let’s start with the obvious: beating the S&P 500 is hard. Really hard. The collective wisdom of the market is embedded in the index, which is why it’s so often pointed to as the benchmark for professional (and amateur) investors alike. And yet, everyone wants to beat it. The allure is just too strong. The issue, however, is that most people can’t.

In fact, if you’re picking individual stocks, you’re probably doing something closer to gambling than investing. As we point out in Why Picking Individual Stocks Is a Fool’s Game, the odds of picking stocks that consistently outperform the market are slim at best. Most stocks fail to beat the broader index, and even professional fund managers, with teams of analysts and statistical models, often fall short.

But let’s say you’re not most people. Let’s say you’re a pro—or at least you think you are. How does one consistently beat the market when picking individual stocks is a fool’s game?

The answer, according to Cliff Asness, the co-founder of quantitative hedge fund AQR Capital and an all-around finance nerd, lies in taking one or both of two primary types of investment risk: concentration risk or leverage risk. Oh, and if you’re really serious about this, you’ll probably also want to get comfortable with shorting, especially during bear markets.

Buffett’s Playbook: Concentration + Leverage

Warren Buffett, the greatest investor of all time, has provided a masterclass in how to beat the market for decades. But contrary to popular belief, Buffett doesn’t just buy stocks and let them magically compound. He operates with a clear set of principles that AQR’s researchers have broken down:

“In essence, we find that the secret to Buffett’s success is his preference for cheap, safe, high-quality stocks combined with his consistent use of leverage to magnify returns while surviving the inevitable large absolute and relative drawdowns this entails. Indeed, we find that stocks with the characteristics favored by Buffett have done well in general, that Buffett applies about 1.6-to-1 leverage financed partly using insurance float with a low financing rate, and that leveraging safe stocks can largely explain Buffett’s performance.”

Translation: Buffett used both concentration risk (in cheap, safe, high-quality stocks) and leverage risk (using insurance float) to generate returns (no shorting¹).

Buffett’s strategy involves two key components:

1. Concentration Risk: Buffett has invested in cheap, safe, high-quality businesses—think Apple, American Express, Coca-Cola, Disney, and GEICO. These companies have strong competitive moats, predictable cash flows, and excellent management. But here’s the kicker: all of Berkshire Hathaway’s returns come from just 12 companies². Buffett is not diversified in the traditional sense. He’s concentrated, and he’s comfortable with that because he knows he’s betting on the best.

2. Leverage Risk: Buffett doesn’t just invest his own money. He uses float—the premiums collected by his insurance companies that won’t need to be paid out immediately—as a form of low-cost leverage. Essentially, he’s borrowing money to invest in high-quality assets, magnifying his returns.

This combination of concentration and leverage has allowed Buffett to outperform the market for decades. Even when he makes mistakes—and by his own admission, most of his capital allocation decisions have been mediocre³—the winners in his portfolio more than make up for the losers.

But Isn’t Leverage Bad?

Ah, leverage. The word itself sends shivers down the spines of risk-averse investors, and for good reason.

“My partner Charlie says there is only three ways a smart person can go broke: liquor, ladies, and leverage. Now the truth is—the first two he just added because they started with L—it’s leverage.”
—Warren Buffett

Buffett’s not wrong. Leverage, when used recklessly, can destroy you. Just ask Bill Hwang, the man behind Archegos Capital. At its peak, Hwang’s family office Archegos managed over $36 billion in assets. But Archegos was leveraged 5-to-1, meaning even a 20% drop in his portfolio would wipe out his equity. Spoiler alert: that’s exactly what happened⁴.

Buffett, on the other hand, has always used leverage responsibly. His 1.6-to-1 leverage ratio means that it would take a 63% drawdown to wipe out his equity—a far safer margin of safety.

The lesson here is simple: leverage is not inherently bad. When used in moderation and applied to high-quality assets, it can magnify returns in a highly positive way. But if you go full Archegos, don’t be surprised when your portfolio implodes.

Tips

For Everyone

1. Buy High-Quality Assets

The easiest way to do this is with index funds. Index funds, by their nature, contain both good and bad companies, but over time, they increase ownership of the good ones and decrease ownership of the bad ones. Think of it as momentum investing for dummies.

Why It Works: Index funds are typically weighted by market capitalization, meaning they buy more of the stocks that are going up and less of the ones that are going down. To borrow a phrase from Peter Lynch, index funds automatically “water the flowers and cut the weeds.”

2. Be Patient

Beating the market isn’t a sprint; it’s a marathon. The long-term compounding of high-quality assets is where the real magic happens.

For Pros Only

3. Leverage: Borrow to Magnify Returns

Leverage is the ultimate double-edged sword. When used responsibly, it can significantly boost your returns. When used recklessly, it can wipe you out.

Buffett’s use of insurance float is a prime example of how to use leverage responsibly. By borrowing at a low cost, he’s able to amplify his returns without taking on undue risk.

But leverage isn’t just for billionaires with insurance companies. Many hedge funds and professional investors use modest leverage to enhance their returns. The key is moderation. A 1.6-to-1 leverage ratio, like Buffett’s, provides a healthy margin of safety. A 5-to-1 ratio, like Archegos, is a recipe for disaster.

4. Short Selling: Profit in Bear Markets

The third strategy for beating the market is short selling—betting against overvalued assets or the broader market during downturns.

Short selling is not for the faint of heart. It requires a deep understanding of market dynamics, a willingness to go against the crowd, and the stomach to handle sharp losses, particularly during bear market rallies. But when executed correctly, it can protect your portfolio during bear markets and even generate significant profits.

Professional investors often use short selling as a hedge against their long positions, reducing overall portfolio risk. In adverse market conditions, shorting can mean the difference between a small loss and a catastrophic one.

As Why All Professional Investment Strategies Should Have a Short Component points out, incorporating shorting into your strategy is an essential tool for navigating volatile markets.

Conclusion

Beating the S&P 500 is not for the faint of heart. It requires taking risks—concentration risk, leverage risk, or both—and, for the truly ambitious, using short selling to navigate bear markets.

Warren Buffett has shown us that it’s possible to consistently outperform the market, but his success didn’t come without calculated risks. He concentrated his portfolio in high-quality businesses and used leverage responsibly to magnify his returns.

For most investors, the best approach is to buy and hold index funds. But for the pros out there, the path to beating the market lies in understanding the risks, taking them responsibly, and sticking to a disciplined investment strategy.

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Inverteum is a proprietary trading firm that specializes in long-short algorithmic strategies to generate returns in both bull and bear markets. We strategically short sell and opportunistically deploy leverage with the aim of consistently beating the S&P 500.

More from Inverteum

1. Buffett thinks shorting stocks is a bad idea.

2. Buffett: “Our satisfactory results have been the product of about a dozen truly good decisions – that would be about one every five years – and a sometimes-forgotten advantage that favors long-term investors such as Berkshire.”

Source: Berkshire Hathaway 2022 Annual Letter to Shareholders p.6

3. Buffett: “In 58 years of Berkshire management, most of my capital-allocation decisions have been no better than so-so. In some cases, also, bad moves by me have been rescued by very large doses of luck. (Remember our escapes from near-disasters at USAir and Salomon? I certainly do.)”

Source: Berkshire Hathaway 2022 Annual Letter to Shareholders p.6

4. Hwang has even gone to jail for defrauding the banks he worked with and manipulating stock prices.