John Rekenthaler of Morningstar asks “what are the possible paths to outperformance?” and comes up with three options.

1. Find the “market’s dummies”: First, he says, there is the “traditional approach” in which “there seems to be plenty of opportunity for the gifted minority to relieve the dumb of the burden of wealth.” But, Rekenthaler maintains, “it hasn’t worked that way.” Instead, “most of the stock market’s would-be wolves have instead been deceived sheep – dumb money that has fooled itself into thinking that it is smart.” While acknowledging that professional managers tend to be paid regardless and that there are a very few exceptions to the analysis who do seem to represent genuinely smart money (e.g., Warren Buffet and David Swensen), he offers that “beating the dumb money is a difficult path.
2. Take more risk and be different: More viable, Rekenthaler suggests, is the second option: “find different money.” Essentially, he takes on the concept of the stock market as a necessarily zero-sum game of winners (due to skill or luck) and losers (due to bad decisions) in each trade. Rekenthaler says that, instead, “investors have varying conceptions of risk” and, therefore, it is “possible that the willing loser has made a sound, rational choice.” With different concepts of risk (for example, different time horizons), “two parties will value [a given] stock differently.” When a fund manager evaluated on rolling three-year periods sells a stock from a currently distressed industry to a buy-and-hold investor, the latter may be “a willing loser, but not a dumb one.” He suggests that this is the strategy behind many “smart-beta” funds.
3. Timing the market: The third approach, according to Rekenthaler, is a version of timing the market. He notes that “the purest form of market-timing, moving into and out of stocks in a binary fashion, has a poor track record at best,” but opines that “there’s much more to be said for the more cautious versions.” He continues: “raising a bit of cash during bull markets, to be put to work when and if stock prices slump, is a sensible way to beat the indexes.” He then cites Warren Buffet’s agreement to recapitalize Goldman Sachs in 2008, trading $5 billion for “a $500 million annual dividend and the possibility (which soon occurred) of selling his shares back to Goldman at a 25% premium.”