Is it smart to try to beat the market?
Reprinted courtesy of MarketWatch.com.
To read the original article click here
Of all the many ways investors shoot themselves in the feet, it’s hard to find one that’s more common than the age-old quest to “beat the market.” As research consistently shows, most people who try this wind up way behind the market instead of ahead of it.
This column, adapted from a chapter in my book Financial Fitness Forever, is the second in a series that addresses the four most important choices every investor faces. The others involve where you put your trust, how you diversify, and how you control risk.
Shoot a bit lower
However, investors by the hundreds of thousands (maybe millions) seem to be determined to beat the market. If you are among them, you are likely to make many bad choices:
- You will trust the wrong people for information and advice.
- You will pay too much in expenses and fees, and probably in taxes, too.
- You will take unnecessary risks.
- You will fail to diversify properly.
- You will almost certainly spend too much time worrying about your investments, and this anxiety will sap your peace of mind.
- You’ll focus on short-term results that don’t mean much instead of long-term returns that can change your life.
- You’ll find yourself susceptible to whims, fads, trends and emotions.
I can tell you one very reliable way to beat the market, at least some of the time: Put your money in the bank. The stock market goes down approximately one day out of every three; on those days, you wouldn’t lose. You would indeed “beat the market.”
In theory, it’s possible that your market-beating efforts will lead you to great success. But it’s much more likely that you’ll eventually give up after you have misused precious time and lost a lot of your precious dollars.
My advice: Instead of trying to outsmart other investors, do your best to achieve the returns of the market. Over the long haul, this will put you ahead of the majority of investors.
In theory, achieving market returns is fairly easy. The U.S. stock market is efficiently represented by low-cost index funds and ETFs that track the S&P 500 Index. The same holds true for most of the major asset classes that I recommend.
What’s stopping you?
But in real life, two things keep investors from achieving those returns. First, various expenses, fees and inefficiencies are inevitable — at a very minimum, somebody has to package an index, make it available to you, and keep records.
All this costs money. Giving up a tiny 0.1 percentage point of return to expenses seems insignificant. And it is, in the short run. But over your investing lifetime, it can cost you thousands of dollars. Savvy investors pay careful attention and try to pay only for what is truly necessary or beneficial.
Second, and more relevant here, investor behavior gets in the way of achieving market returns. Because this behavior is in our control, that’s where I will focus you attention in the rest of this column.
When hot goes cold
Investors trying to beat the market inevitably put their money into funds that have had recent hot performance. This is a serious mistake. If you could read the questions I get from investors, you’d see how difficult it can be to make sound decisions when you’re worrying about short-term developments.
People who know they should make some change to get their risks under control or improve their diversification often put off making the change because of recent market uptrends or downtrends — or sometimes because they’re worried about what the Fed might do regarding interest rates.
Instead of looking at what’s likely to be the best in the long-term future, far too often investors are concerned mainly with what happened last week or what might happen next week. The collective result is misguided market timing. When they finally act, it is often the result of emotions more than evidence and a rational plan.
A Boston research firm, DALBAR, Inc., has studied this behavior since 1992 and shown how the results for investors can be disastrous. I described this research in a column you’ll find here. Here’s the very short version: As we move money in and out of the market based on our fears and our greed (in other words, our urge to beat the market), we collectively wind up with less than half the return we would have had if we had just stayed the course.
It gets even worse. Many investors work hard to choose managers who can beat the market, then they ignore the advice of those very managers and in fact undermine that management by buying, selling and making their own trading decisions.
Talk about shooting yourself in the foot! All this is in pursuit of trying to beat the market.
You might think this is an anomaly, but academic studies have repeatedly identified this pattern of behavior.
Next time you’re feeling a strong emotional urge to outsmart the market by buying or selling an investment, stop for a moment and ask yourself these two questions:
- Would I make this decision if I knew I had to live with it for 10 years before I could change it?
- If I’m about to buy something, do I believe in it enough that if it lost 20 percent of its value I would want to buy more?
If you ponder a few questions like that, you may be able to avoid having your emotions dictate your actions. And you may find it easier to resist the temptation to beat the market.
There’s a good alternative that I strongly recommend: Invest in low-cost index funds. They will save you money, save you grief, save you time and save you taxes.
For more on this topic, check out my podcast “Will you try to beat the market,” in which I read the full chapter from my book.
Richard Buck contributed to this article.