The allure of beating the market
Wouldn’t it be great if you could consistently outperform the stock market to increase the return on your investments? Perhaps you’ve already had some success in accomplishing this feat. Or perhaps you’re just starting to invest and figure this is what people try to do when they decide which mutual funds or stocks to buy.
While I won’t deny many people try to outperform the market, the reality is few people do it for an extended period of time. Years of research demonstrate the elusive “beating the market” mantra is mostly marketing hype. Larry Swedroe and Andrew Berkin recently updated their 2015 book, “The Incredible Shrinking Alpha” with more data and research studies about the inability of amateur and professional investors alike to beat the market.
From a financial planning perspective, expecting above average returns to meet your goals increases the likelihood you won’t achieve your goals if your superior performance doesn’t materialize. However, if you can achieve your goals with typical returns (or perhaps even lower returns with more modest goals), chances are higher you’ll reach your financial goals.
You can experience peace of mind with your investments with a thoughtful plan that acknowledges the short-term fluctuations but maintains focus on achieving your goals. Components of this plan include clearly identifying your goals and time period for achieving them.
If you anticipate meeting your goal in the next few years (such as buying a house or sending a child to college) then the money you have accumulated should not be invested in the stock market. Unfortunately violating this principle can result in tremendous anxiety, especially during the numerous periods of time when stock prices are significantly lower.
Another component to a successful investment plan is understanding the factors that contribute to positive returns. In Swedroe’s book, he identifies several of these factors including stocks with lower prices relative to their book value or earnings tend to provide above average returns (although certainly not every year). Also known as value stocks, these have been one of Warren Buffett’s favorite types of companies. Another factor cited by Swedroe to deliver higher returns is investing in smaller companies. No surprise, smaller companies also have more risk associated with them but this risk carries additional rewards.
Once you’ve identified the factors (such as value or size), you can explain the majority of why a particular mutual fund outperformed the overall stock market. Years ago these relationships were poorly understood, which made it easier for fund managers to claim it was their professional skill, but today we have better insight into the true drivers of market returns.