Why Is It So Hard to Beat the Market?
When it comes to investing, the holy grail for many investors is the pursuit of beating the market. The allure is understandable: who wouldn't want to outsmart the collective wisdom of the stock market, reaping returns that sore above the benchmarks?
However, beating the market is quite challenging. While tales of legendary investors like Warren Buffett or Peter Lynch abound, their successes are often the exception rather than the rule.
In this article, we'll discuss "the market" and what it means to "beat the market." We'll also discuss portfolio composition and how to measure your portfolio's performance relative to the relevant benchmarks.
What is "the market"?
In finance, "the market" generally refers to the S&P 500. The S&P 500 represents a diverse cross-section of the U.S. stock market and is considered a benchmark for the overall performance of the large-cap equity asset class (stocks). The index is composed of 500 of the largest publicly traded companies in the U.S. based o factors such as market capitalization, liquidity, and industry representation. It covers about 80% of the total market cap of publicly traded companies and includes companies from various sectors such as technology, healthcare, finance, consumer goods, and industrials. Investors typically compare the returns of their portfolios to those of the S&P 500 to assess how well their investments are performing relative to the broader market. While large, the S&P 500 is not the market.
There are other benchmarks for other asset classes, such as the Russell 2000 Index and the Aggregate Bond Market. The Russell 2000 is an index that tracks the performance of approximately 2,000 small-cap stocks in the U.S. While there is no strict definition of what constitutes a small-cap stock, they are typically considered to have market caps ranging from a few hundred million dollars to a few billion dollars. The Aggregate Bond Market refers to the collective market for investment-grade bonds issued by governments, corporations, and other entities. It includes a diverse array of fixed-income securities, such as Treasury bonds, corporate bonds, mortgage-backed securities (MBS), and asset-backed securities (ABS).
How do I "beat" the market?
To "beat the market" means achieving a higher return on your investments than the overall performance of a designated benchmark. Outperforming a benchmark requires a combination of securities that are within the benchmark or applicable to the benchmark. The concept of beating the market is often used as a measure of investment success or skill. It implies that an investor has generated returns that exceed what would have been earned by simply holding an index fund or a similar passive investment vehicle that tracks the benchmark.
Commonly used benchmarks aside from the S&P 500 include:
- S&P MidCap 400 Index for the mid-cap asset class,
- Russell 2000 Index for small-cap equities,
- CRSP Micro Cap Index for micro-cap equities,
- Aggregate Bond Index for fixed income,
- MSCI EAFE Index for international equities, and
- MSCI Emerging Markets Index for equities in emerging markets.
What if my portfolio doesn't beat the market?
Although beating the market, as defined by the specific investor, might be the ultimate goal, a successful investment experience does not require a portfolio to beat the S&P 500. A successful investment experience allows an investor to meet their long-term objectives, within their specific risk tolerance, while remaining dynamic. Beating the market, however "the market" is defined, is not as important as exceeding your custom benchmark.
If you wanted your entire portfolio to beat the market, you may need to take on a level of risk that does not align with your investment objective. An increased level of risk may not be a good idea due to:
- High volatility: Stocks are inherently volatile assets, subject to fluctuation in market sentiment, economic conditions, and company-specific factors. This portfolio would be likely to experience significant price swings, which can lead to substantial losses during market downturns.
- Lack of diversification: Without diversification across different asset classes such as bonds, real estate, and cash equivalents, a portfolio may be vulnerable to prolonged periods of underperformance or capital erosion.
- Increased risk of loss: Stocks carry the risk of permanent capital loss, especially if the companies in which you invest experience financial distress, bankruptcy, or other adverse events.
- Emotional decision making: The volatility of the stock market and increased risk may lead to emotional stress, anxiety, or impulsive decision making when equity markets decline for a prolonged period (ex. 2020 saw -30% in a short time; 2022-2023 was -20%+).
Depending on an investor's situation, portfolios should generally have exposure to both equity and fixed income asset classes. Ultimately, the success of a portfolio should be evaluated based on whether it helps investors achieve their financial goals, rather than solely on its ability to beat the market.
How should I measure my portfolio's performance?
When it comes to measuring the performance of your portfolio, consider changing your definition of "beating the market." Instead of only comparing your entire portfolio to the S&P 500, compare the specific asset class allocations of your portfolio against their relevant benchmarks.
Additionally, consider comparing the performance of the percentage of your portfolio allocated to the relevant asset class against the performance of the corresponding benchmark. For example, if your portfolio is 60% large cap and 40% fixed income, you may want to compare the 60% performance to that of the S&P 500 and the 40% to the Aggregated Bond Market, rather than comparing the entire portfolio to one of the indexes.
Lastly, you may consider using the weighted average performance of all the benchmarks against the total performance of your portfolio. Doing so will help uncover your portfolio's "true" performance against the benchmarks.
Ensure your portfolio is helping you achieve your financial goals.
It's essential for investors to have a clear understanding of their objectives, risk tolerance, and investment strategy, and to focus on achieving their long-term financial goals rather than chasing short-term market outperformance.
To learn more about the investment strategies we use for our clients, we invite you to contact one of our Wealth Advisors. Or, if you'd like to receive a complimentary Portfolio X-Ray that examines your portfolio against the relevant benchmarks, you can contact us here.
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