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To beat the market, you can’t be in it

The Holy Grail of many investors is to beat the market. If not beating it through our own efforts, we expect our advisor or broker to beat it, too. After all, if an advisor or fund manager cannot beat the market over time, after making a small allowance for ancillary services provided, then an investor should just stick to index funds.

Investors are comfortable with the market. The stock market, as a whole, represents the American economy. As the saying goes, don’t bet against the American economy. I don’t. My faith in the American economy to perform strongly over the next decade and century is so high as to border on the pollyannish.

It is easy to simply match the market and go along for the ride. Buy some index funds and stop thinking about it. Still, most of us want to do better. The market is the average return. Who thinks they are merely average? Surely not you and me. Average is for that other guy – we are better than that!

While we are comfortable with the market, the only way to beat it is to not be in it. At least not entirely. Being in the market means to own a representative array of stocks across industries, sizes and valuations. If you do this, your returns will most assuredly be very close to market returns, minus the fees you paid. A typical portfolio for an investor seeking market outperformance will contain a smattering of stocks and a bunch of stock mutual funds. This gives him or her more than a thousand stocks – a certain recipe to match or trail the market, not beat it.

If the market is a Chevy, you can’t beat it by driving another Chevy. You need to drive a Porsche instead. Once you strap yourself into that Porsche, you are no longer in the familiar market. You are in private equity, or real estate, or hedge funds, or some other so-called alternative asset class. For the most part, these alternatives entail more risk. At the very least, they require you to step outside your comfort zone and accept investment characteristics that are quite unfamiliar.

If you’ve gotten used to the notion that you can convert your portfolio to cash with a phone call or the click of a mouse, you will have to surrender that notion if you invest in private equity or real estate funds. My clients and I have investments that we simply cannot liquidate; we have to wait a few years and see how it all works out, whether we want to or not.

Some investors might believe that they can out-run a Chevy by driving another Chevy – by driving it better and faster. After all, race car drivers are of varying skill levels, so why not stock pickers? True enough, but think about how one Chevy driver beats another Chevy driver. He must push the car at higher speeds farther into corners before braking. He must navigate those corners with his car barely clinging to the road surface. He must pass where there is no room to pass. He must grit his teeth and power through spinning car wrecks happening in front of him. In other words, he must take more risk. He must run a different race than everyone around him. Beating the market, and winning a car race, means taking more risk than everyone else is taking.

The oldest and truest rule in finance is that there is no free lunch. Earning higher returns than the market means to either take more risk than the market offers, or it means to get away from the market entirely. There is nothing wrong with earning market returns. I only suggest that you let go of the notion that you or your advisor will beat the market by being in it. If your stock portfolio is diversified across industries and styles, in actively managed funds or accounts, you are in the market. You need to ponder whether or not this outcome is worth the higher fees of actively managed accounts.

If you are going to race like a Chevy, don’t pay for a Porsche.