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What’s the best way to beat the share market?

If you want to beat the market, what’s the best way to do it?

Is it best to utilise small caps? What about mid-caps with good growth potential? How about dividend shares?

One of the best ways to deliver strong returns is to choose a high-quality index-based exchange-traded fund (ETF) like iShares S&P 500 ETF (ASX: IVV). ‘Value investing’ is a strategy that’s often referred to, but surely all investing has some sort of value judgement? 

There are definitely shares that will beat an index over a certain period of time. But which strategy is best?

Dividend shares

Dividend shares are an interesting idea to try to beat the market. They already generate a profit, which is a helpful factor in beating the market as share prices should follow earnings. Receiving dividends can also be an important part of returns from the market, particularly from shares like Transurban Group (ASX: TCL) or Commonwealth Bank of Australia (ASX: CBA).

However, the problem is that many shares classified as ‘dividend shares’ have reached the ‘mature’ stage. They’re unlikely to grow very fast in the foreseeable future, so unless you’re good at trading in and out of shares at the right time it’s unlikely that a dividend yield-focused portfolio would beat a growth portfolio.

However, there are plenty of good, growing businesses that pay a dividend – it’s just that they wouldn’t be counted as a dividend share.

Mid-cap growth shares

Mid-caps are small enough that they have plenty of growth potential still, but they’re large enough that they should be pretty safe from some of the start-up risks facing small caps.

If you can put together a portfolio of strong mid-cap growth shares at good prices you’re likely to beat the share market over a period of three to five years and perhaps the longer-term. Imagine if you could go back a year or two and buy a portfolio of shares like Altium Limited (ASX: ALU), Appen Ltd (ASX: APX), Xero Limited (ASX: XRO), Afterpay Touch Group Ltd (ASX: APT), Xero Limited (ASX: XRO), A2 Milk Company Ltd (ASX: A2M) and Breville Group Ltd (ASX: BRG). Some portfolios have included many of these names. 

Whilst each mid-cap may not deliver the biggest return because they’re already quite large, I think choosing the a strategy of growth mid-caps is more likely to deliver strong returns with each individual pick.  

Small caps

If you can find that small cap that turns into a large cap before most other people, then you’re going to be onto a huge winner.

The problem is, unless you have a crystal ball it can be quite hard to know which shares will go on to truly do extraordinary things. There are plenty of shares that have flopped after showing potential for a period of time like Slater & Gordon Limited (ASX: SGH), GetSwift Ltd (ASX: GSW) and Blue Sky Alternative Investments Limited (ASX: BLA).

The hope is that if you can find one fantastic small cap, it will make up for the other ones. Imagine you pick three shares for a time period of two years and two of them literally go bust and those shares are worthless. However, the third pick goes on to generate a return of 900%. Your average return across the three looks great, even though two were terrible.

The amount of information that’s available these days makes it very difficult for a regular person to get an advantage, unless you can do a huge amount of research. One of the small caps that I have high, long-term hopes for is Bubs Australia Ltd (ASX: BUB).

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Tristan Harrison owns shares of Altium. The Motley Fool Australia's parent company Motley Fool Holdings Inc. owns shares of Xero. The Motley Fool Australia owns shares of and has recommended Transurban Group. The Motley Fool Australia owns shares of A2 Milk, AFTERPAY T FPO, Altium, and Appen Ltd. The Motley Fool Australia has recommended BUBS AUST FPO. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. This article contains general investment advice only (under AFSL 400691). Authorised by Scott Phillips.

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