beating the market, part 1: mind the gap

Something you should know about me: I loathe the phrase “beat the market.” What does that even mean? Which market are we talking about? Domestic? International? Large-cap? Small-cap? Junk (sorry, “high yield”) bonds? And over what time period? If you want to beat the market, chances are you’re going to have some down years, but your strategy might play out in the long run — so how long a run are you looking at?

No one ever talks about that, though. It doesn’t make for good cocktail party stories. No, when it comes to investing, people like to talk about how they’re making money off of derivatives, or how they bought in to a small company before its stock split five times, or how they’ve got a super-exclusive financial adviser who hit it big last year, or — more often — how they almost did all those things. (“You should have seen the one that got away!”)

No one ever talks about the Behavior Gap.

For those of you not familiar with Carl Richards, “behavior gap” is the term he coined for the fact that the investor return is much lower than the investment return. That is to say, most people don’t even match the market, much less beat it. A company known as Dalbarresearches such things, and according to them, in the twenty years between 1990 and 2010, the S&P 500 earned an average 9.14% return each year, while the average investor earned 3.83% per year over that same amount of time. 3.83%! You could probably have beaten that with a halfway decent CD ladder — and those CD’s would have been federally insured!

So what’s the problem? Why’s this happening? Well, there are a number of culprits:

Investors take on risk disproportionate to the reward. Like I said above, people like to make big bets on complicated and/or risky investments. Derivatives. IPO’s. Biotech stocks. Gold. “Hedge funds” (the irony of the name sets my teeth on edge). Trouble is, while you can indeed strike it rich this way, you’re statistically much more likely to go bust.

Investors tend to churn. We’re programmed to believe that the way to succeed at something is to work at it, to constantly touch our portfolio, selling the “losers” and buying the “winners”. The trouble is, each time we make a transaction, we incur costs that eat at our returns. Brokerage commissions are the obvious one, but if you’re buying or selling stocks (especially small-caps), you need to watch out for bid/ask spread, as well. Market makers aren’t buying (and/or selling) your stock for charity, you know!

Investors sell low and buy high. It’s embarrassing how regularly this happens. In crashes like the ones of 2000 and 2008 (and 1929, and 1987, and many others), people are always convinced that This Time It’s Different. They sell all their stocks for bargain basement prices, convinced that the right thing to do is to Wait Until Things Get Better. So they wait until the stock market rallies, and then they buy back in when it’s “safe”, i.e. when stocks are high. Had they simply held on to their stocks in the first place, they would have gotten all their money back and then some; as it is, they have just taken a sledgehammer to their investment returns.

In short, we are our own worst enemies.

But while all of this is morbidly fascinating, in a manner quite similar to a train wreck, it is beside the point. True, most people who attempt to beat the market end up trailing it by an embarrassingly wide margin. But the sad fact of the matter is, people who ask “how can I beat the market?” — or even “how can I match the market?” — are asking entirely the wrong question.

What’s the right question? I’ll take that up next week. Fair warning, though: like most truths of finance, it’s more boring than you’d like.