The value it provides as a hobby I cannot judge and will be different for everyone. From a purely financial perspective, however, I see that many times the returns are lacking and this is not surprising as building a portfolio that can “beat the market” is very difficult. Below I will explain why.
What does beating the market mean?
Let’s assume that as an amateur investor I would like to invest in shares. Then, broadly speaking, I have three options: (1) I purchase shares of companies I believe will do well going forward, (2) I buy one or several exchange-traded-funds (ETFs) that track an index such as the S&P 500, or (3) I choose to participate in an actively managed fund or funds and I will allow a team of professional fund managers to make the investment decisions on my behalf.
I may believe that if my portfolio had a return of 8 percent over a calendar year, I had a good year. Unfortunately, the 8 percent by itself is rather meaningless, in terms of performance, if we do not compare it to a benchmark. If a benchmark such as the S&P 500 made a return of 10 percent, it was not a good year for my portfolio! Because with my limited portfolio of shares and all the effort and time I invested in managing it, I made a return that is lower, despite assuming more risk in my portfolio, than if I would have simply owned an ETF tracking the S&P 500. Therefore, I can only speak of having had a good year if my portfolio outperformed the S&P 500, net-of-fees, thereby beating the market.
Similarly, actively managed funds have a benchmark and those funds that do well, outperform the benchmark consistently over a multiple-year period, again net-of-fees. The reality is that even for these professionals who spend all their working hours on selecting financial instruments that they believe will offer a return over and above the expected return, beating their benchmark is very challenging.
Why is beating the market so difficult?
If we focus on the shares of companies that are part of the S&P 500 index, then we know that in such a highly liquid market, the price of the shares is based on the continuous selling and buying by many market participants (millions of shares are traded daily on the New York Stock Exchange, e.g.). These trades are made based on the public information that is available; information related to the state of the economy, geo-political events, central bank policy guidance, industry-and company-specific information, influential analyst reports, just to name a few. All the new information that will have an impact on future cash flows of the company you are interested in partly owning, will affect its share price directly. Since this stream of information is continuous, share prices change continuously. However, this new information needs to be interpreted. And it is in this interpretation that some believe lie opportunities to beat the market. Behavioral economists argue there are imperfections in financial markets and attribute these to a combination of cognitive biases such as overconfidence, overreaction, representative bias, information bias and various other predictable human errors in reasoning and information processing.
So then ask yourself these fundamental questions: do you believe the market is always right and the share price reflects the fair market price at all times? Or do you believe that there are indeed market imperfections that can be taken advantage of? In the latter case, you believe that beating the market is possible, however, you are faced with the task of recognising when the market is wrong. And not only that, for you to make an excess return if the market is wrong, the market also has to recognise it was wrong before prices adjust.
The above by no means is meant to discourage those who wish to build their own investment portfolio, merely to argue that it is no easy task to manage one that can consistently outperform a benchmark. If you feel up for the task, then don’t let the above stop you. In either case, we at Blacktower are here to help. Contact us today to hear what we can do for you.
Add disclaimer: This communication is for informational purposes only and is not intended to constitute, and should not be construed as, investment advice, investment recommendations or investment research. You should seek advice form a professional adviser before embarking on any financial planning activity.
when I first glanced at this headline I thought it read ‘Why stitching socks is so difficult’. I thought, well that's random!
By Ian from Beiras on 16 Jan 2023, 07:06