Beating the Market Is Hard. Really Hard.

IF you walked into a Certified Financial Planner’s office, they would never tell you that your financial goal is to “beat the market.” They would start with a budget, financial analysis, and estate plan, then help you construct a prudent and holistic strategy to meet your financial goals. This, unfortunately, is not how most investment portfolios are sold to investors.

Investment managers often think in different and even conflicting terms whereby they try to justify their fees by building market-beating portfolios. And while many investors spend their time and money trying to beat the market, for the average person this is irrelevant to their financial goals. Most people don’t need to beat the market. They need to optimize their income/skills and then allocate their savings in a manner that gives them a high degree of financial certainty in the future.

Ironically, the history of the investment management business can be summarized as selling the hope of superior returns in exchange for the guarantee of high fees. Most expensive active managers do not outperform basic index funds after accounting for taxes and fees. As shown in Table 0.1, according to S&P’s annual SPIVA report cards, 94% of active managers will underperform their benchmark over a 20+ year period.² That’s astounding and just goes to show how hard it is to beat the market.

Table 0.1: Fund underperformance rates – US equity categories

But don’t worry, it’s okay if you’re not outperforming the market. After all, beating the market is not a practical financial goal and trying to do so usually involves taking more risk to generate higher returns. While this approach may be suitable for certain individuals, it often leads to increased volatility of returns and poses greater behavioral challenges.

To emphasize this point it can be useful to discuss William Sharpe’s arithmetic of active management:

• Before costs, the return on the average actively managed dollar will equal the return on the average passively managed dollar and;
• After costs, the return on the average actively managed dollar will be less than the return on the average passively managed dollar.³

I don’t love the distinction between “active” and “passive” investing because we’re all ultimately active for various reasons, but that doesn’t change the fact that less activity is, on average, superior to more activity, all else equal.

This is basic math. If the stock market generates an 8% return in a given year, more active investors are likely to incur additional taxes and fees that less active investors can avoid. This means, on average, the less active investors will generate better returns than the more active investors. And this explains why so many active managers don’t beat the market in the long run.

Instead of trying to “win,” you should formulate a sound financial plan and then apply a strategy that matches that plan and your needs over time. Don’t worry if your strategy isn’t consistently optimized or beating the market. They say perfect is the enemy of the good and this is nowhere more applicable than portfolio construction. In Chapter 13 we talk to William Bernstein, who teaches us that a “suboptimal portfolio you can stick with is better than an optimal one you can’t.”