In our previous newsletter here, we delved into the importance of understanding cash flows and the insights they provide if you have yet to read the previous two posts I highly encourage readers to take the time to read them. The first newsletter can be found here. I want to take a slightly different approach to our following newsletter and explore some market theories. One central concept that guides our investment decisions is “beating the market.” Beating the market means achieving a higher average return than the general market average. In other words, your investment gains outperformed the collective average. If the market returned an average of 8%, and you achieved a return of 8.5%, you were successful. You exceeded the collective average by 0.5%. However, if your performance consistently falls below the market average, it’s essential to question why? and whether your current investment decisions are maximizing your capital’s potential.
Numerous academic studies have tackled this topic, ranging from the belief that it’s impossible to beat the market consistently to the mindset of traders seeking outsized returns for superior performance in the market. This newsletter isn’t focused on debating whether individual investors can beat the market consistently. As far as I’m concerned, whether the market can be beaten or not is irrelevant to reaching our financial goals. However, understanding the central conversation surrounding beating the market can help guide our investment decisions. We need to consider if the potential rewards are genuinely worth the effort, the risk, and the cost associated.
For full disclosure, I invest to beat the market. It keeps me engaged, and I find pleasure and enjoyment in this endeavor. Hard work and dedication can lead to achieving our desired outcomes. Nevertheless, we must grasp the concept of beating the market. Suppose an investor can consistently outperform the collective average market return. In that case, it implies that they possess some skills, information, or insights that surpass those of the collective “market,” which includes all participants buying and selling on the open exchange. Many investors are unaware of the benchmark or have misconceptions about their performance due to lack of relevancy.
We should ask ourselves… If my average return is not greater than the market’s average, if I could have gained a better result by investing in the broad market without any additional efforts, what am I even paying for?
For those readers who may be new to stock market investing, several indexes and sub-sectors are used to gauge overall performance. For example, the S&P 500 tracks the top 500 companies in the United States and is a barometer for the U.S. equity markets. Other examples include the Nasdaq 100 (QQQ), which primarily focuses on technology-based companies, and the Dow Jones Industrial Average(DJI), among others. Regardless of the benchmark chosen, the critical question for an investor is: If I had invested my money in the chosen benchmark and done nothing else, what would my return be compared to my current performance?
This discussion doesn’t encourage or discourage attempts to beat the market. Instead, it serves as a tool to guide decision-making for investors. Investors should take the time to assess their current market knowledge and willingness to improve their investing skills while accepting an increased exposure to risk.
Key considerations for investors include:
1. Desire for education regarding stocks and market conditions.
2. Tolerance for risk.
3. Attitude towards the possibility of losing money.
4. Investment time horizon
5. Commitment to navigate a learning curve.
5. Attitude towards the potential of underperforming the market and being wrong.
I love the challenge of learning about the market and becoming a better investor. Given my age and lifestyle, I also have a higher tolerance for risk. However, this may only be the case for some readers, and investors must decide which investment style best fits them. It’s interesting to note that most investors do not consistently beat the market over time. In theory, if you had a method to beat the market consistently, that would imply you are in the upper quadrant of some of the most skilled money managers in the world. Considering the implications of transaction costs, psychological stress, and taxes, the pursuit of beating the market may only sometimes be worthwhile. There’s a cost associated with everything, whether it’s the time and resources needed to outperform the market or the cost of potential losses and underperformance.
Another option is to engage the services of a wealth manager. Before I continue, I would like to emphasize that my statements and opinions are not a discredit to financial professionals or wealth managers. I know many excellent financial advisors who cover many financial topics beyond just stock market investing. However, understanding how financial service workers are compensated and their performance benchmark will provide us with the necessary information to make more informed financial decisions.
Typically, financial advisors are paid based on assets under management (AUM). This fee ranges from 0.5% to 1% of the client’s assets being managed, depending on the agreement. For example, if you have $100,000 being invested, the manager is paid $1,000. If you invested $1,000,000, they would be paid $10,000 annually for managing your investments. Since most of us won’t have an initial investment of $1,000,000 or even $250,000, the idea is to manage clients’ investments and let time work with compound interest while minimizing risk. As the financial advisor gains more clients and their investments grow, their AUM and the 1% fee across multiple clients grow their annual management fee.
How does this relate to you as the reader? If you decide to use these services, that’s perfectly fine. However, you must ask yourself if the services you’re receiving give you a market edge that helps you outperform the market or, at minimum, match the market’s performance.
Let’s consider an example: If the market’s average return over 10 years was 9%, but your return was 10%, did you beat the market? Considering that each year your investments grew and you paid your advisor 1%, your return decreases from 10% to 9%. If taxes and transaction costs are associated with your account over that period resulting from placing trades, the return is likely to be even lower. In this scenario, you underperformed. The investor is no better off than if they had invested the money in an index and done nothing else. I understand that many clients prefer to pay for the convenience of someone else handling their money, which is perfectly reasonable. Again, this discussion isn’t about whether one decision is better or worse. It’s about ensuring investors know what they’re paying for and why to make better-informed investment decisions.
The other side of the coin is when investors take it upon themselves to manage their investment accounts. This is the camp I fall into. In all fairness to advisors and investors, this is challenging. There’s no way around it. There’s a reason why wealth managers are paid what they’re paid. It requires attention to detail, constant learning, and a genuine passion for investing. I greatly respect those who prefer to avoid taking on this responsibility. As an account manager, you are ultimately responsible for managing your accounts, making trades, and handling tax implications. Your performance determines your success and failure. It’s challenging, but the essential point is how many personal investors lose money simply because they don’t track their performance at all!
As financial services have become more readily available, trading has become more accessible. This has opened up investing to many participants who previously didn’t have easy access. While this has allowed investors like myself to participate in the market, we also need to realize that none of the brokers or services encouraging us to trade ever prompt us to consider some simple questions before hitting the buy button.
Here are some questions to consider:
1. What is my desired annual return?
2. Do I have the skills to achieve my desired return, or do I need time and practice?
3. Do I have a system for tracking my returns and evaluating how I can improve?
4. Do I have mentors and resources to learn and adapt to market conditions?
5. Do I have the temperament to deal with market fluctuations and volatility, or would I be better off using passive investing or financial services?
Regardless of the answers to these questions, they will better prepare investors to navigate the ups and downs of their investment journey. When I began investing, I knew nothing. I didn’t go to business school, I hadn’t worked in financial services, and I didn’t have the necessary resources to outperform the market. Because of this, I needed to tailor my expectations and allow room for a learning curve.
Too often, investors rush to buy popular stocks and hold them without considering how their current performance and actions are being evaluated. They need to ask themselves if they would be better off investing in an index fund and doing nothing else. It’s vital to assess whether selling a losing investment and reinvesting the money in a more consistent investment would yield better results, considering the time factor and the opportunity cost of the money that could have been invested elsewhere.
To summarize, three primary options are available to investors: broad market investing with self-management of your accounts, using financial services and hiring a financial professional, or individual stock investing.
Broad market investing has pros and cons. On the positive side, there are no management fees, and you will always match the market’s returns. It’s a hands-off approach with low tax implications and transaction costs. However, your returns will be average, and it requires some basic knowledge and portfolio management skills. It also lacks portfolio diversity.
Using financial services and hiring a financial professional also have pros and cons. On the positive side, it’s hands-off, and you can rely on the expertise of the professional. They can assist you during psychologically turbulent market conditions, discouraging panic or ill-informed decisions. However, the 1% management fee takes away from your overall market returns, and you’re reliant on an outside entity for investment success.
Individual stock investing gives you complete control over your portfolio, and your decision-making determines your success and failure. It has the potential for greater returns, and your knowledge and investment education tend to be higher. However, it comes with a steep learning curve, higher potential losses, and requires additional work and time for research and learning.
Ultimately, investors need to weigh the pros and cons of each option and align them with their financial goals. I like to combine both broad market investing and individual stock investing. I passively invest in broad market indexes while actively researching and making independent investment decisions. I am fully aware that my own decisions come with the potential for underperformance as well as the potential for outsized returns. I accept that I may be wrong and lose money, as it’s an inherent risk. Many great wealth managers successfully help their clients reach their financial goals. If not, our role in financial services would not exist. Our role is to listen to our clients and help them achieve their best financial well-being.
You can take a personal inventory using the questions presented and evaluate which investment style fits you and your financial goals the best. As always, these are my own opinions and not financial advice.