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Investing in the stock market can seem simple for some and complex for others and getting to a “good” investing outcome can be done in many ways. I would argue that your mindset and expectations about investing and the way you approach investing has much to do with your perceived outcome.
Therefore, there are three questions about investing that all investors need to answer before you buy any stocks or bonds.
1. Is my goal to “beat the market?”
While I am certainly oversimplifying things here, most investors can be divided into two categories; those that are seeking returns equal to the market and those seeking returns that are better than the market. It is crucially important for you to decide and choose which camp you are in.
If you decide your goal is to simply seek returns equal to the market, your investment path should theoretically be straightforward. Low-cost index funds or ETFs can do a respectable job of delivering market-like returns.
(However, Vanguard found that even that isn’t so simple. Their Advisor Alpha study says that investors without advisors perform about 3% worse per year when evaluating long-term periods. Poor investor behavior accounts for nearly half of the underperformance.)
If your goal is to outperform “the market,” then you have two options to get that done. First, you can invest in “the market” using index funds but attempt to only be invested during good times and not tough times. This is called market timing. Most people claim this cannot be done, but many of those same people will try to do it anyway (i.e. moving their investments to cash prior to a major election).
The other way to beat the market is to not invest in the entire market, but only parts of the market (i.e. overweighting certain sectors, buying individual stocks, etc.).
The key here is to understand is that beating the market is incredibly hard to do, especially on a consistent basis. In fact, according to S&P Dow Jones Indices, 88.99% of large cap US mutual funds have underperformed the S&P 500 index over 10 years (as of April of 2020), and these are run by professional money managers who invest millions and billions of dollars for their investors.
2. What is my definition of “the market?”
This sounds simple, but individual investors answer this question incredibly inconsistently. Some say “the market” is the Dow Jones Industrial Average. Some say it is the S&P 500. Others say it is the Russell 3000. So, which is it and why does this matter?
If your goal is to beat the market, then it is important that you identify what you’re actually up against. Likewise, if your goal is to get market-like returns, it’s important to know what that actually means.
When we talk about “the market” in our firm, we are talking about the entire global equity market, which includes U.S. stocks, international stocks, emerging markets, small cap, large cap, etc. But, if you simply want to track the S&P 500, you are only talking about U.S. Large cap stocks. Right there is a key difference.
When you evaluate your own portfolio, be sure you are comparing apples to apples. This will help prevent a gap between your expectations and your outcomes.
3. How much time do I need to effectively measure the performance of my strategy?
No matter what investment strategy you choose, you need to understand a proper timeframe for evaluating your outcomes. All investments are designed for certain periods of time. Some investments are better for short-term time periods while others are better for the long-term.
If you invest in a strategy that is designed for the long-term, but you are evaluating your outcomes after 1, 3, or even 5 years, you’re missing the boat. I once heard a phrase that says it best: “Measuring the success or failure of a diversified portfolio after 1, 2, or even 5 years, is a bit like pulling up daisies to see how the roots are doing.” It makes no sense.
We all know not to expect flowers to bloom overnight, so why would you expect stocks to return 6%, 7%, or 8% every year. The average returns we usually punch into our retirement calculators are just that: averages. Those averages include data from long time periods of 10, 20, or even 30 years.
So, can you rely on the average returns of your stock portfolio after just five years? Not quite. Doing so would be like relying on a vaccine that has worked on literally four out of five people. Would that make you feel comfortable enough to take it? Probably not. You would want much more data and testing. In the finance world, more data equals more time.
Is your goal to beat the market? If so, what is your definition of the market and how much time do your investments require before you have enough data to do a meaningful evaluation.
Answering these questions will not guarantee investing success, but doing so can help you avoid major disappointments and help prevent against poor decisions.
Investing involves the risk of loss and investors should be prepared to bear potential losses. Past performance may not be indicative of future results and may have been impacted by events and economic conditions that will not prevail in the future. Therefore, it should not be assumed that future performance of any specific security, investment product or investment strategy referenced in the article, either directly or indirectly, will be profitable or equal to the corresponding indicated performance level(s). No portion of the article shall be construed as a solicitation to buy or sell any specific security or investment product or to engage in any particular investment strategy. In addition, this article shall not constitute the provision of personalized investment, tax or legal advice, and investors shall not assume this article serves as a substitute for personalized individual advice. Information contained in this article may have been derived from third-party sources that CAWM believes to be reliable; however CAWM does not control such information and does not guarantee the accuracy or timeliness of such information and disclaims all liability for damages resulting from such sources.