"Doctor, Did You Beat The Market?" Who Cares!

Recently I had a conversation with a potential physician client during his Financial Strategy Consultation. You can learn more about this consultation by clicking here (but only if you're serious about taking control of your financial life. Skeptics need not bother):

Financial Strategy Consultation

Two of the questions he asked me were "How do I know you're going to beat the S&P 500 Index?" followed by "How have your clients' portfolio returns been compared to the S&P 500?"

I love these two questions because they immediately let me know that he doesn't understand how markets work. Even without looking at his portfolio, I also know that he doesn't have an investment plan.

Better yet, I know that if he's open to new ideas and can get rid of his biases, I can help him.

So let me teach you a little investing lesson today. How 'bout it?

Just to lay it out for the uninitiated, the S&P 500 Index is a measure of US stocks (specifically large company stocks). Financial advisors and the media like to compare the returns of portfolios and specific mutual funds to it. They practically salivate when they can show that such and such fund manager's return "beat" that index.

And why not? There's a ton of money to be made for the fund manager--likely they'll see huge inflows of money going into their fund as investors pile in to the fund since it beat the index. And that'll line the fund manager's pockets.

Financial advisors also do this. They compare their client's portfolio returns to the S&P 500 and in years where the portfolio has higher returns than the index, they can claim they have some sort of skill. Of course when the portfolio has lower returns than the index, they blame it on bad luck.

Imagine doctors justifying their medical decisions like that!

Suppose I come up to you and show you the returns of a hypothetical investment--we'll call it Investment A--and compare it to the S&P 500 Index over a 10 year period and the total returns are as follows:

Investment A +80%

S&P 500 Index -10%

Can you conclude that Investment A beat the S&P 500 Index?

Physician investors, financial advisors, mutual fund managers, and anyone else who has no clue about designing and managing portfolios would naively say "Yes" and bask in their glory.

Not so fast cowboy (or cowgirl).

What if I told you that Investment A is a bond fund that tracks the performance of the bond market and that the time frame is 2000-2009. In that time US stocks lost -10% for the decade but US bonds were up +80%.

Is it fair to compare Investment A's performance to that of the S&P 500 Index? Can you conclude that Investment A beat the S&P 500?

No and No.

Why?

Because bonds and stocks are two different investment classes. It's sort of like randomized placebo controlled trials for different drugs in medicine. In those trials you have to compare a drug to a placebo. Otherwise you can't necessarily conclude that the drug worked. OK not a perfect analogy but you get the point.

You can't compare bond returns to stock returns.

But there are plenty of other ways individual investors (including physicians), financial advisors, and others use subtler tricks--whether on purpose or just due to plain ignorance--to claim that they beat the market.

Suppose in your portfolio, you have a mix of multiple different investment classes. In that case if your portfolio had a higher rate of return than the S&P 500, all you're doing is playing mental games with yourself and comparing your portfolio's return to the wrong benchmark.

I could give you many more examples of this, but that's a good start.

Which brings me to a much more important point.

If you or your advisor are comparing your returns to the wrong benchmark, you probably don't have a good grasp of investment portfolio management. You also have to question the competency of the advisor. And then you've got to wonder whether you have an investment plan, philosophy, or strategy at all.

If you've got a sound investment philosophy and strategy based on academics and financial science, the S&P 500's return simply becomes irrelevant. Your portfolio does what it does. Your rate of return is what it is.

So in my approach to investment management, I don't get questions like what the physician above asked me simply because those are the wrong questions to ask. And I proactively educate my clients about these issues--something every good investment advisor should be doing.

So if you're ready to create a sound investment strategy, stop worrying about irrelevant issues, and start taking control of your investments, you can start by setting up your Financial Strategy Consultation by clicking here:

Financial Strategy Consultation

Be warned: if you have no intention of taking action and want to continue plodding along in the fog without an investment plan or strategy, and you're not open to new ideas, then this consultation will be a waste of your time and mine.