When beating the market is not enough

Beating the market is an obvious goal for active investors. After all, if you're not beating a zero-effort passive index, why go to all the time and trouble of being active?

This is true for both private and professional active investors:

• Private investors often obsess over whether or not they beat the market last year, or over the last few years.
• Professional investors often explicitly benchmark their funds against a market index such as the FTSE 100 or FTSE All-Share.

Conventional thinking says that if an investor has beaten the market, over whatever timeframe, they have done well. If they've underperformed the market, they've done badly.

But while I think beating the market is a necessary goal it is not a sufficient goal for achieving the real outcomes that most investors want.

You can beat the market and still perform badly

Here's the conundrum from my perspective:

Like most investors I want to know if my investment efforts are good or bad, so I need something to compare myself against.

My portfolio is split about 50/40/10 between FTSE 100/250/Small-Cap companies, so I use the FTSE All-Share as my benchmark. It's not perfect, but it's simple to track and reasonably close to the size and geographic characteristics of my portfolio.

Now that I've defined what “the market" is, what do I mean by “beating the market"?

There are lots of ways you could define it, but in my case I have the following performance goals, all of which are relative to the FTSE All-Share:

1. Have a higher dividend yield at all times (at the portfolio level)
2. Produce higher total returns over any 5-year period
3. Have lower risk (using beta and maximum drawdown) over any 5-year period

So in simple terms I want it all: A higher yield, higher total returns and less risk than the market.

But there's a problem.

We have just seen the FTSE 100 break through to new highs after a wait of more than 15 years.

Just think about that. 15 years in which the market made zero capital gains and for much of the time was actually losing money. And that's before factoring in inflation.

With inflation factored in the FTSE 100 would need to be at something like 9,500 to have held its value in real terms.

So while beating the market may be a very sensible goal, I don't want to jump for joy just because my portfolio has beaten something which hasn't grown, at all, for 15 years.

My point is that, like most investors, I'm not investing to beat the market; I'm investing to achieve my financial objectives, which are not the same thing.

Most investors don't really want to beat the market anyway

What most active stock-picking investors really want is either:

1. A lump sum, preferably at least 10 years in the future, which will be used to pay for something or generate a retirement income, or
2. A dividend income today which they can live on, either partially or completely.

Neither of those goals has anything to do with beating the market. In fact, when I talk to investors about what they're looking to achieve they tend to say things like:

“If I could get a return of 10% a year I'd be happy"

I think that's a very telling statement which shows that many (most?) people don't generally think of their investment goals in terms of beating the market.

They might decide whether they're any good at investing or not based on whether they beat the market (the old “did I beat the market last year?" question), but their ultimate goal isn't to beat the market; it's to achieve their financial objectives, whatever they may be.

To achieve those objectives the investors I've spoken to would generally prefer their investments to increase steadily each year, with as little risk as possible (which is what Bernie Madoff promised and is the key reason why he was so successful at attracting investors).

So I think it would be a good idea if active investors used fixed, absolute return goals in combination with their traditional goal of beating the market.

An absolute return goal for active UK stock pickers

If I'm going to suggest an absolute return target, what should it be?

I do hear “10% a year" bandied around quite a lot. I think that might be achievable by some investors over the long-term, but it may be too hard to reliably achieve over the medium-term (5 years) which is where most portfolios are measured.

There is no magic to measuring performance over 5 years, I just think it's a good timeframe which is not too short (where the random market will dominate performance) and not too long (where you may lose faith in your skills if you underperform for several years in a row).

Rather than just picking a number out of the air, such as 10% a year, I think a reasonable goal for an actively managed, UK-focused, relatively defensive, relatively large-cap portfolio like mine would be to beat the UK market's long-run rate of return over any given 5-year period.

Fortunately the UK's long-term returns have already been published in the Barclays Equity Gilts Study. It shows that over more than a century UK equities have returned an annualised rate of return of 5% after inflation.

I would hope to be able to beat that rate of return over any 5-year period, regardless of what the market is doing, so in addition to my existing goals I will add a fourth performance goal focused on absolute returns:

4. Produce total returns of more than 5% above CPI inflation over any 5-year period

If I failed to achieve any of my goals for a given period then I would write myself a note, explaining why the goal had not been achieved, much as the Governor of the Bank of England has to do when the bank's inflation target boundaries are breached.

Your own portfolio may be very different to mine in terms of the size of the company's you invest in, or the riskiness of those companies, so if you decided to use an absolute return goal it could be very different to my 5% real return target.

However, regardless of the exact goal, I think most active investors should focus on beating some absolute rate of return over the medium-term as much as they already focus on beating the market.

If they did that I think they would be much more likely to achieve their true long-term investment objectives, rather than worrying about what the market is currently doing.