Is Your Investment Goal To Beat The Market?
When someone contacts me about getting help with his or her investments, more often than not during the discussion a question comes up about the level of returns I‘ve gotten for my clients. I would like to address the various implications of such a question in the hope that it may help some readers better understand why that’s the wrong question to be asking and what investing is really all about.
To answer the question directly: it varies depending on the client. Wait, you might ask. Shouldn’t the goal for everyone be to beat or at least get a similar return as the market? In a word, no. First of all, what is the market? The most well-known U.S. stock market benchmark is the Dow (or Dow Jones Industrial Average). But that represents the average price-weighted return of only 30 of the largest U.S. company stocks. If you own stocks in other U.S. companies, the S&P 500 index might be a better benchmark. Or the Russell 2000. Which one should you pick?
More likely, though, your investment portfolio is diversified. That means you are holding investments in multiple asset classes, categories of investments that behave in different ways. And the returns from different asset classes can vary widely. Large U.S. company stock returns typically differ from those of small publicly-traded U.S. companies. The returns of sovereign bonds (bonds issued by foreign governments) usually bear no resemblance to those of the stocks of companies in those same foreign countries. Other asset classes in which you can invest include commercial real estate, commodities, and mortgage-backed securities, just to name a few. I track over 15 different asset classes when recommending investments to clients. So what benchmark would be appropriate to compare returns for an investment portfolio diversified to this extent? I would have no idea.
So if there are no useful benchmarks that you can apply, and if an advisor’s clients’ returns vary based on their different investment strategies, perhaps you can select the advisor with the highest average return across his or her clients last year. But again, what would that tell you? Maybe such a result was due to the advisor just happening to have a higher percentage of clients with more aggressively-managed investment portfolios at the same time that market returns happened to be very positive. What would happen to those clients’ returns if market returns were to turn negative? And what does that tell you about the investments the advisor would be recommending for you?
There are three elements that advisors (and investors) do have the ability to control when making investment choices: the cost, the taxation, and the risk of each investment. This is a much better way to focus your decision-making, whether for your own investments or as a criterion for selecting an advisor. Although cost is easy to understand – the more expensive the investment, the lower your returns – it should not be the sole consideration. Managing investment risk is the bigger challenge and requires the greater effort. After all, we should be investing not for entertainment or for riches but rather as a managed funding source for all the things we want to be able to do in our future. This is what we’ve been saving money for, and we should not risk gambling any of it away on some fruitless investment scheme based upon promises and hope. Trying to grow our money too fast puts us at risk of suffering bigger losses during the inevitable market cycle downturns. And the relationship between risk and return is not linear. There are times (such as now) when we have to take a lot more risk in order to get just a little more return. Good investment management is about balancing the needed return to support your future goals against the risk to which you would be putting your savings, while at the same time keeping investment costs down and optimizing for taxes. That’s a much better approach than making decisions based on historical returns.
If it’s an advisor for whom you are searching, you are unlikely to run across one that consistently and significantly underperforms the market. That’s because his or her clients would ultimately have left and the advisor’s business would ultimately have failed. Looking for an advisor who makes it easy for you to make good financial decisions, whether for investing, retirement planning, education planning, or any of the other areas that will contribute to your successful financial future, is likely to serve you much better than grabbing the one whose clients happened to have the best investment returns at some point in time.