I'm sure you've heard it before. The phrase "beating the market" is one of Wall Street's most enduring and alluring refrains When I ask people what they mean by it, most people say beating the market means outperforming a benchmark index like the S&P 500. Others (usually MBA-types) dress up their answers in technical jargon involving risk-adjusted returns. Still others look at me blankly. They either don't have a clue what I'm talking about or they think the question too foolish to even warrant an answer. (It's like the old Bill Cosby sketch about dating the philosophy major in college. She used to go around asking questions like "Why is there air?" Bill Cosby, on the other hand, was a phys-ed major.)
Please don't get me wrong. I understand the desire to beat a benchmark. I'm a competitive kind of guy. But what does beating an index have to do with anything I really care about? My financial goals involve paying for my kids' college education and having enough money to retire in dignity. Beating the market is cold comfort indeed, if I still end up old, cold and eating Alpo when I'm 85.
A lame excuse
It is time to wake up to the fact that "beating the market' is a pretty lame excuse for an investment goal. At its roots, "beating the market" is little more than Wall Street hype. It is asales pitch dreamed up by the brokerage community because it works for the broker. First of all, it gives the broker something to talk about no matter what the market is doing. Second, it is one-size-fits-all investment advice. The broker doesn't need to know anything at all about the prospect.
Brokers also love it because it is so effective. The phrase "beating the market" appeals to our greed. As soon as we hear it, we begin to worry about missing an opportunity. We find ourselves wanting to believe the broker and we actually begin to sell ourselves on the idea. I have a friend--normally a very bright guy--who sent all kinds of personal information (including his social security number, account statements, etc.) to a stranger who cold-called him from a boiler room in New York. What kind of Jedi mind trick did this guy from New York use to get my friend to divulge his personal financial information? He just claimed his hedge fund could "beat the market."
We can do better
There is a better way to judge the performance of your financial strategy and it has nothing to do with "beating the market." The concept is simple, but it will keep you on track no mater what else is happening in the world around you. It starts with setting clear financial goals and then focuses on measuring your progress toward those goals. (For more about setting goals, I refer you to my recent post Getting SMARTER about your financial goals.) Here's how it works.
Assume the following:
- Years to retirement = 20
- Current retirement savings = $650,000
- Annual contribution to retirement savings = $12,000
- Desired annual income in retirement (today's dollars) = $150,000
- Inflation = 3.5%
Given inflation, that $150,000 desired income will grow to almost $300,000 by retirement. Financial planning convention says I should plan on taking somewhere between 4% and 8% of my retirement portfolio each year in retirement. If we split the difference and assume 6%, then my portfolio needs to be worth $5 millionby the time I retire ($300.000/6% = $5,000,000.) This implies that from today going forward, I need my portfolio to earn 10% annually for the next 20 years.
After I know what my annual return needs to be, I can track my actual return relative to my needed return. In this case, if my actual performance is below 10%, I know I am getting further from my goal. The more my performance lags, the worse off I become. On the other hand, if my portfolio earns better than 10% per year, I know I am ahead of my goal. This approach gives me a lot more information than simply tracking performance relative to an index. But remember, these calculations need to be updated at least annually. If the market moves dramatically one way or the other, or if other assumptions change, you may need to update even more frequently.
Another key benefit of targeting return instead of an index is that it allows me to better manage portfolio risk. Just as my assessment of return is better when it is goal-driven, so also is my assessment of risk. Understanding the target return for a portfolio helps me gauge the minimum amount of risk my portfolio must assume. This contrasts with the typical Wall Street approach of pushing investors to take as much risk as they can stand.
The idea of beating the market has gained widespread acceptance over the years. What started out as a Wall Street sales pitch has become institutionalized as a one-size-fits-all investment goal. In your effort to acheive your financial goals, you can do better. By focusing performance measurement on your progress toward your goals, you can keep your portfolio in line with the reason you are investing in the first place.