Every investor would love to find an investment that allows them to participate in all the upside of the market while steering clear of the downside. That doesn’t exist. The truth is that investment return is strongly correlated to the amount of risk taken. Two extreme examples of this are venture capitalists and CD investors. Venture capitalists can make a lot of money because they risk significant loss of principal. In fact, the majority of venture capital investments go bust, but it is the one or two home runs that make it all worth it. Individuals that place money in a CD do not have any risk of loss, and subsequently receive very little in return.
Know Your Goal
Oftentimes people invest for a specific reason or goal. One of the most common goals for investors is to retire comfortably. A comfortable retirement may be defined differently by each investor, but it has to do with not having to worry about money and living a lifestyle they desire. Other common investor goals include college funding and building a legacy. “Beating the market” is rarely, if ever, identified as a primary goal of investors.
Maximizing Return
Maximizing return may seem an obvious desire of any investor. Of course we want to maximize our returns. But that means we need to take risk – maximum risk if we are truly looking to maximize return. The payoffs of such a strategy can be quite generous, or totally devastating. Most people don’t really try to maximize their returns, instead investing becomes a tradeoff between our need to grow our assets and our ability (both financially and emotionally) to tolerate loss.
We often do a decent job of defining how much the portfolio needs to grow (i.e. average 7% per year will achieve the goal), yet we seldom define how much we are willing and able to lose should markets move against us.
Managing Risk (Loss)
Investors who have any desire to manage the risk of their investments are concerned about losing money in a down market. It is important to quantify, in dollar terms, how much you could realistically afford (both financially and emotionally) to lose in a downturn. We don’t know if a 10% correction in the market is a great buying opportunity or the first step down to losing much more until well after the fact. Because we can’t predict the market (nor can the experts), it is important that we don’t lose more than we are able or it may cause us to sell low as we seek immunity from additional losses.
If your portfolio has any component of “managing risk” you should expect to underperform the market during bull markets. Unfortunately, that relative underperformance can influence investors to forget about their primary goals, and focus on beating the market instead…or at least keep pace with the market. This temporary shift in focus can influence investors to take on more risk than they can handle.
When we shift our focus from our personal goals to achieving performance similar to some benchmark, we often forget to consider the downside. Because we are not considering the downside, the calculation of risk becomes skewed. We underestimate the risk because we are simply not considering the downside…we are too focused on beating the market.
Beating the Market
The media is obsessed with market indices. It’s always about “how did you do versus the market?” The constant chatter comparing a mutual fund, ETF, or hedge fund to an index (such as the S&P 500) can influence us to also compare the performance of our portfolio to the S&P 500, or some other index. And brokerage firms make it very easy to do that since many statements will illustrate your personal return for the period and also list a series of index returns. Performance that pleases you and is in line with your goals can become disappointing when comparing to index returns in a bull market.
Just because you value the management of risk doesn’t mean you can’t “beat the market” over time, or that you will significantly “miss out”. In fact, if risk is being managed well, you should greatly outperform the market during down markets. And that relative outperformance in a down market greatly enhances your long-term performance. But, it’s not about beating the market anyway…it’s about reaching your personal goals.