Why do we buy and sell stocks? The easy answer for most of us is to make money or in other words end up with more money than we initially started with. The next question then becomes, “How much money do you want to make?” The easy answer again comes from our inherent greed which is to make as much money as humanly possible, however, the more sophisticated answer that you hear often in the business media and in the investing industry is that your investments must make more money or generate returns than are greater that what the stock market as a whole is generating. In other words, financial success and bragging rights are enshrined to those who can “beat the market”. If the stock market goes up 10 percent in a year, it isn’t enough anymore for a portfolio to earn 10 percent. You must beat that 10 percent to be deemed a successful investor. If you earn 8 percent, than you are deemed a failure.
This emphasis on beating the market has become entrenched especially within the financial services industry. For people managing other people’s money in products like mutual funds, pension funds and other types of managed portfolios, your investment pedigree and more importantly, your performance bonus is defined not only by if you have earned returns in excess of the market returns but also by how much, or the “alpha”. This pressure to beat the market has now trickled down to the masses. Investment products of many stripes are being cranked out with a marketing premise that their fund will outperform the market.
This is insane and must stop. Stop trying to beat the market!
The reality is that to outperform the stock market on a consistent basis, year–in and year out is impossible. Even the greatest investors in the world like a Warren Buffet or a Peter Lynch will underperform the market but still earn a reasonable return on their investments. There are enough studies out there that between 70–80 percent of actively managed portfolios CANNOT even match the market rate of return of a stock market index. So in spite of the mountain of empirical evidence, why are we still obsessed with trying to beat the market?
The Rarified Air That Is Financial Services
One reason comes down to our inherent human desire to compare ourselves with others. We are benchmark junkies and we will always be. It also has a lot to do with our desire for competition and to win. At the end of the day, it really comes down to cash. In the financial services industry, performance bonuses and growing your assets under management drive a big part of compensation. To justify those huge bonuses, metrics are needed. For those who manage portfolios, the make or break metric is outperforming the market and generating alpha. To beat any index requires taking on more risk and money managers will take liberties to over extend a portfolio’s risk profile to score some extra percentage points to top up their bonus. For the average investor the concept of beating the stock market should be ignored completely.
If we go back to my original question of why do we buy and sell stocks, the more appropriate response for an individual investor would be to earn a reasonable return that allows us to meet our long term financial goals, at a level of risk that we are comfortable with. As individual investors, we are not shackled to nor judged by our peers or Wall Street compensation committees. Leave that neuroticism and insecurity to them. Our objective should be to generate income to meet our long term financing needs, be it retirement, going to school, or anything that is meaningful to our lives.
The Most Important Benchmark: Inflation
If there is a benchmark that all portfolios need to strive for, the most important is to earn returns that are at least greater than inflation. As time marches on the cost of goods we will consume will more or less go up. As prices go up the purchasing power of our savings will go down. Our dollar will buy us less in the future than it does now. While many Government statistics say that we are currently in a low inflation world with cost increases that are very minimal, just go to the grocery store or fill your car with gas, or check out the tuition fees for university and quickly you can see that for goods and services we will need 10 to 20 years from now, we can expect to pay more. In order to keep our purchasing power in the future high or in line with future price increases, we should be investing in assets that will generate at the very least sufficient returns to protect us from losing our purchasing power. Right now we are living in a world with inflation officially tracking at 1 to 2 percent, so ideally we need to be earning returns of at least 1 to 2 percent. You may be to young for this but in the 1970’s inflation was running in the double-digits. It is quite possible that at some point in the future that we could return to those days so managing your investments so they are inflation protected is always important.
The Next Most Important Benchmark: Your Life
The best and least risky way to earn enough to match inflation is to own fixed–income securities such as GIC’s or corporate bonds because the interest rates they pay out factor in inflation expectations. However, as we’ve said, we are saving and investing our money to help us achieve long term goals and it is likely we will need to earn a bit more than just 1–2 percent. To do so you’ll need to move your investments up and along the risk curve. You need to ask yourself what your life will look like when you achieve your financial goals and when it is all going to do down. How much money will you need to sustain your lifestyle? How much time do you have to get there? Once you have some kind of vision on what your life could look like you’ll need to crunch some numbers to see what kinds of investment returns you’ll need to achieve. Unless your timeline is less than 2 years, you should have a meaningful bit of time to work with. The internet is filled with financial calculators that can estimate the growth of your portfolio under a variety of conditions.
Past Performance Can Be A Guide to the Future With The Right Sample Size
As human beings our decision making is often formed by events in recent history (aka Recency Bias) so if stocks go up 20 percent last year then by default people will assume stocks will grow at a similar rate in the future. Same goes with hot sectors. If technology stocks have been doing well, we’ll put more money into to those stocks. More often than not chasing last year’s winners will often lead to disappointment. If however we take a much a bigger picture approach and use data spanning 100 to 125 years, we can gain a more insightful perspective in that stock prices over the long period covering both boom and bust economic cycles have on average returned 6 to 8 percent. With this and the inflation protection in mind, we can put together a more realistic benchmark to work towards. Depending on your risk tolerance, it is much more realistic to strive for financial returns in the 4–8 percent range. Anything above that is gravy and a bonus and will offset the guaranteed low periods that will be sure to happen. Stocks will gyrate well above and well below these levels, however if you ignore the pressure to try and beat the market returns of the day by remaining disciplined and focused on executing your investing strategy, you will less likely to be disappointed and less likely to take irrational actions that will impair your returns even more.
Another Perspective on Chasing Alpha: The Behavior Gap
Instead of focusing on trying to beat the market, another approach is to maximize your decision making power. Financial planner Carl Richards has coined the term Behaviour Gap to represent the amount of money investors leave on the table when making investment decisions based on emotion. The Behavior Gap is the difference between the posted return on an investment and the amount of return you actually earned while you have owned the same investment. For example if over the course of a year, Apple stock increased 10 percent, however within the same period and in the time you owned it, it went up 4 percent. The Behaviour Gap would have been 10–4=6%. There are many factors that could have driven the 6 percent gap, but they are often driven by the amount of emotion that factored into the decision making. Mr. Richards argues that if you stay disciplined and focused on your investment strategy as well as keeping the emotion out, you can reduce the Gap and create additional wealth in your pocket without worrying if you are beating the market.
In 2013, the S&P 500 index was up over 25 percent. If you earned 13 percent by owning an S&P500 ETF for some period in 2013, the financial pros would say you had a bad year. If you take out the neuroticism that is associated with trying to beat the market, and focus on working towards long term returns that will allow you to meet your financial goals, that 13 percent return in the context of what stocks have earned in the past 100 years along with an inflation rate that is running at 1–2 percent, suddenly put things in its proper perspective.
The next time someone or an investment company starts talking about how they beat the market for the last 10 years, smile…and move on. It’s OK to not beat the market as long as you are staying disciplined and committing your long term strategy to achieve your financial milestones. When you sign up to invest, you are running a marathon, not a sprint.