Beating the Market, the Holy Grail?

A week or so ago I read an article indicating that most investors don’t think their advisors can consistently beat the S&P; 500 index. The article then goes on to describe a new service that matches mass affluent investors (those with $100,000 to $1.5 million to invest) with investment managers who normally cater to only ultra wealthy investors.

First of all I think we need to define some terms. An investment manager is someone (or a team) that manages investments. This might be a separate account manager or a mutual fund manager. Typically the investment manager might manage money in a given style (large growth, small cap value, and emerging markets equity are some examples). Typically the manager’s performance will be judged against a benchmark that is most closely related to their investment style. Some typical benchmarks are the S&P; 500, the Russell 2000, the EAFE index (foreign stocks). If the manager is actively managing the portfolio (not indexing) then judging their performance against this benchmark index is wholly appropriate.

A financial advisor is someone who works with clients on a variety of issues such as retirement planning, estate planning, tax planning, and of course investments. While some advisors do pick individual stocks for their clients, many advisors function in a consultative role, acting as a manager of managers for their client’s portfolios. What this means is that we will devise an investment plan as part of our client’s overall financial plan. Implementation will typically be done using a mix of mutual funds and ETFs to fill the “style buckets” in the plan. The funds may be active, passive, or a mix of both.

Back to the question I raise in this post’s title. Is beating the market the Holy Grail? In evaluating your answer to this question, one should examine their goals and expectations, as well as their definition of the “market.”

The article I mentioned uses the S&P; 500 as the market index, as do many investors and journalists. Over the decade 2000-2009 this index lost money, beating it was not difficult for most investors with a diversified portfolio.

As an advisor, I typically will construct a blended benchmark that is a weighted average of the benchmarks that most closely reflect the mix of investment styles in a given client’s investment plan. We then track the portfolio against this blended benchmark. Generally a client’s investment plan is a sub-set of their overall financial plan which looks at the client’s overall financial goals. A key element of setting financial goals is to quantify how much will be needed and by when. Tracking a client’s progress towards these accumulation targets is far more important in my mind than investment performance vs. the market.

On the other hand, if you are hiring a money manager to manage a portion of your investment portfolio then this manager should absolutely be judged against an appropriate benchmark. An active manager should beat the benchmark over time; a passive index fund should closely track the benchmark index.

As with all things in the realm of financial planning and investments, investors should start out with a set of expectations. For example, if you are hiring a financial advisor go into the relationship with some expectations. What do you want the advisor to do for you? How might you define financial success?

This also holds true when choosing investments or investment managers on your own. You should have an expectation for each investment you make whether you hire a separate account manager, or buy mutual funds, ETFs, stocks, bonds, etc.

If you don’t set expectations, you will never truly know if you are successful or if you need to make some changes.

Please feel free to contact me with your questions. 

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