Beating the Stock Market

Here’s an interesting perspective on investing success from Cullen Roche of Pragmatic Capitalism. Roche makes a couple of unique points. One is that for a true passive investor, you shouldn’t be focused on “the market” represented by stock market indexes. You should be focused on all the financial assets out there. He argues that a portfolio passively invested in financial assets (a global financial asset portfolio) does better much of the time than being invested in the portfolio recommended by advocates of passive investing.

Another point is that instead of trying to beat the market you should be trying to beat the average investor. People make a lot of mistakes when they try to beat the S&P 500, which is very hard to do. Beating the average investor, on the other hand, isn’t very hard. Roche thinks you’ll do better with those two steps: using a global financial asset portfolio and focusing on beating the average investor.

That’s a truly frightening figure.  It means that even if you had left your money invested with a high fee asset manager over this period you very likely beat the returns generated by most of your peers even though most high fee asset managers fail to beat “the market” or index funds. This goes to show that one of the most important decisions is just “getting in the game”. Of course, when one persons gets “into” the game of higher yielding instruments someone else is also “getting out” of that game.  There is a buyer for every seller.  So, by definition, we have to take the aggregate return of all financial assets.  But when we think about personal benchmarks then “the market” is actually a pretty impossible benchmark to beat because we can’t all own stocks (widely thought of as “the market”) and we can’t all generate the aggregate market return of all outstanding financial assets. Therefore, trying to “beat the market” is truly a loser’s game.

It gets even more interesting when you think of how most of us benchmark ourselves.  Since most of us (incorrectly) think of the “the market” as the S&P 500 we end up constructing an impossibly high benchmark for our personal portfolios.  If you were to draw the distribution of asset class returns as shown above you’d quickly conclude that the S&P 500 generates a return that is far from the mean return.  Subtract taxes and fees from that mean return and you likely arrive at a figure pretty close to that average investor figure of 2.1%.  In other words, when we look at the aggregate markets the S&P 500 is a totally inappropriate benchmark for all of us.  Most of us are setting ourselves up for failure before we even begin.   Mathematically speaking, it is an impossible benchmark for all of us to strive for.