Why “Beating the Stock Market” is a Loser’s Game

First of all, what does it mean to beat the market?

Let’s say you are trying to beat the market for large U.S. stocks and your proxy for that market is the S&P500 stock index. Therefore, your goal is to beat the performance of this index (the market).

For example, the index is up 10% last year and your portfolio produced a 14% rate of return. Congratulations, your portfolio beat the market by 4%.

Note, the 4% premium is before any deductions for increased expense and risk exposure.

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How to Beat the Market

Money managers use two primary investment strategies to beat the market: Asset allocation and stock selection.

There are several levels of asset allocation, but in our example 100% of your money is being invested in large U.S. companies. So how much money is invested in stocks versus bonds does not apply. What does apply is the percent of your assets that are allocated to various industry groups: Technology, Oil & Gas, Utilities etc.

The next step is stock selection, which technology stock, and the amount of money that is allocated to each stock. You can beat the market if the manager invests in the right stocks and industry groups.

High Expectations

Some financial advisors create very high expectations when they sell investment services. They know the higher your expectations, the easier it is to sell more expensive investment alternatives that may pay higher compensation to the advisors.

The Crystal Ball

Beating the market means you have to believe a money manager can predict the future performance of the market and individual securities.

Your risk is the manager’s predictions are wrong.

We can tell you it is very difficult to predict the future performance of the markets much less the performance of individual securities. There are hundreds of variables that impact future performance.

Unfortunately, there is no crystal ball that produces higher returns.

Higher Risk

You have to take additional risk to beat the market and hope you are rewarded for taking the risk.

For example, instead of investing in the S&P500 index fund you select a money manager that invests your assets in 30 stocks. The expectation is that these are great stocks and they will outperform the index because all of the lower performing stocks have been excluded.

Therein lies the risk that the money manager is wrong and some of the 30 stocks undermine the results of the better performing stocks.

The bottom-line is your portfolio fails to outperform the index and you were not rewarded for your increased risk exposure when the manager is wrong.

Read: Retirement Mistakes to avoid

GlidePath Wealth Management can help to minimize your risk.

Higher Fees

Active money managers who try to beat the market expect to be compensated with much higher fees than passive managers who match the performance of the markets.

Keep in mind, beating the market is a goal and not a promise. In fact, it is illegal to promise future rates of return and verbal traffic records are worthless.

To be fair, if you select a money manager who charges higher fees, you should judge the “net” performance of the manager after all fees are deducted from your account.

It is also important to note there can be layers of fees. For example, you pay your financial advisor to provide planning services and recommend the right money managers. You pay the money manager to make the right security selection decisions when your assets are invested in the securities markets.

At GlidePath Wealth Management we minimize your expenses.

The Match-the-Market Alternative

There is an alternative to the beat-the-market money managers. You can select a manager whose stated goal is to match the performance of the market. For example, you can invest in an S&P500 index fund that duplicates the performance of that particular index.

Index funds are frequently run by computer programs, so they do not require expensive investment professionals (chief investment officers, analysts, portfolio managers).

Because you are not trying to beat the market you are exposed to substantially lower risk and you pay much lower fees.

The Loser’s Game

There is no free lunch. If you want to beat-the-market, you have to take more risk, pay higher expenses, and hope you are rewarded for both.