Clients often come to us with questions about beating the market: Can it be done? Should they try? What are the odds of success?
The urge is certainly understandable – after all, some of the best-selling investing books in recent years include titles like One Up on Wall Street, Beating the Street, Laughing at Wall Street, and Beating the Market 3 Months at a Time.
Then there’s the fact that the financial media loves to improve its ratings by promoting investment guidance consisting of the idea that beating the market is the only path to success. However, beating the market isn’t as easy as you’ve been led to believe – in fact, giving up this futile pursuit is the surest way to increase your investment efficiency, enhance your peace of mind, and ensure that your investment professional isn’t simply gambling with your money.
Is Your Investment Professional Following as Losing Proposition?
Despite the breathless pronouncements coming from Wall Street and the financial media, consistently beating the market is not an effective or successful strategy – or even an attainable goal.
Over the past eight decades, the aggregate U.S. stock market has generated rates of return averaging between 10 to 12%. At a 10% annual rate of return, your money doubles in just over seven years and quadruples in under 15. Attempting to beat market rates will decrease the possibility that you’ll do as well as the market, all while adding additional – and unnecessary -- risk. Here’s why.
Much so-called “expert” investment guidance leaves out a very important component: Third-party confirmation that the strategies being advocated actually work. Sure, the talking head on TV or the latest best-selling tome’s author presumably believes that his or her strategies work, but that’s not worth much. Without quantitative evidence, they’re essentially asking you to take their word for it. But when it comes to choices that affect your financial future, anecdotal evidence or taking it on faith isn’t enough. You should expect and demand more.
In fact, few active managers and advocates even offer a specific definition of what beating the market means. In our book, legitimately beating the market means fulfilling three conditions:
Achieving an excess return due to skill, not luck;
Achieving an excess return relative to a passive, indexing approach; and
Doing so with the same or lower relative risk exposure
On the other hand, simplistic, vague or non-existent definitions allow people think they’ve beaten the market when, really, they haven’t. Many investment professionals claim success when they’ve really only gotten one or both of the first two right, while miserably failing at the third.
Financial Strategies Based Only on the Facts
Years of empirical evidence shows that you can’t beat the market. Why is evidence so important? Because without it, you can't evaluate a strategy’s efficacy.
After all, with so many strategies floating around out there, how can you decide which, if any, are valid? Many contradict each other; they can’t all be right. Should you believe them all? Try them all? Conduct your own experiments and develop a strategy of your own?
Fortunately, there’s no need to re-invent the wheel: Others have done the research already. Learning from the mistakes of others, rather than making your own, is much more efficient.
It’s simple: When someone claims they have a surefire investment strategy, demand that they present (quantifiable, empirical) evidence that's supported by third parties.
Wealth Strategies: Active vs. Passive?
When it comes to choosing wealth management strategies, the choice often boils down to active vs. passive. Active managers advocate beat the market strategies, while passive managers' objective lies in duplicating market rates of return.
You’ll undoubtedly be shocked to hear that the passive-active choice is controversial amongst investment professionals. Active management has no shortage of advocates, but this dogged adherence to a strategy that’s at odds with vast amounts of empirical evidence means that thousands of wealth advisors are getting paid to chase rainbows and unicorns, essentially gambling with investors’ money.
And why shouldn’t they? After all, they’re only behaving rationally, i.e. in their own financial best interests. As Nobel laureate Paul Samuelson observed, “This message (that attempting to beat the market is futile) can never be sold on Wall Street because it is in effect telling stock analysts to drop dead.” But what’s rational on Wall Street isn’t aligned with investors’ best interests.
Are you chasing rainbows and unicorns?
If you have stock market-related investments and you’re not investing in passively managed asset-class funds, the answer is yes. Every other stock-market-related investment is designed to beat the market.