Why Investors Should Stop Trying to Beat the Market

A Google search of the phrase "beat the market" yields more than 14 million results. Many are investing and trading strategies that promise to outperform a market benchmark.

The idea of generating market-beating returns is pervasive. But there are several reasons to rethink that position.

For starters, investors often use the wrong benchmark.

In the U.S., "the market" typically means the Standard & Poor's 500 index or perhaps the Dow Jones industrial average. But when investors use either of these indexes as a benchmark, they are gauging portfolio performance to one asset class: large-cap U.S. stocks.

Matt Becker, founder of Mom and Dad Money, a Gulf Breeze, Florida, fee-only planning firm for young families, says investors should remember that most portfolios consist of investments beyond large domestic companies. A portfolio may contain not only U.S. large-cap stocks, but also international stocks, small U.S. companies, real estate and bonds. A comparison to the S&P 500 index is off-base for that reason.

"In most cases, it doesn't make sense to compare your personal return to an index, simply because your portfolio will contain at least a few investments that aren't included in that index. If you have some international stocks, for example, those aren't included in the S&P 500. So you should expect your return to be different than the index for that simple reason. Sometimes that difference will be positive, and sometimes it will be negative," he says.

Incorrect benchmarking may lead investors to chase performance of an index that has performed well, or, on the flip side, to bail out of an investment that hasn't looked so good.

"If you compare your personal investment return to the return of an index that doesn't match your portfolio, you run the risk of making incorrect judgments about how your portfolio is doing and taking actions that end up hurting your overall progress," Becker says.

For more than two decades, Boston-based research firm Dalbar has shown that the average investor makes bad moves when it comes to market timing. People tend to pile into a hot investment as it is peaking, and they stampede back out when it turns south. Rather than achieving the desired effect of maximizing returns, attempts at market timing generally worsen portfolio performance.

In its 21st annual report, "Quantitative Analysis of Investor Behavior," Dalbar found that in 2014, the average investor in a stock mutual fund underperformed the S&P 500 by a margin of 8.19 percent. Fixed-income investors underperformed the Barclays Aggregate Bond Index by a margin of 4.81 percent.

Dalbar President and CEO Louis Harvey says the idea that an investor can generate market-beating returns through proper timing is "totally fictional."

He says the financial services and media industries often suggest that one strategy or another is the ticket to outperformance, but they leave out a key piece of the story.

"Whether you're looking at indexes or active investing, it's fiction, as a practical matter, that an investor can get into the market at the start of the period they are measuring, stay in without doing anything and get out at the end of the period. Bottom line: Trying to beat the market is neither prudent nor possible," Harvey says.

A growing number of investors and financial advisors are warming to the idea of a diversified portfolio of passively managed investments. However, says Tony Krance, founder of 401K Plan Advisors in Green Bay, Wisconsin, investors face headwinds when trying to stick to a basic asset-allocation strategy.

"That message has been out there for a long time, but people continue trying to get the hot stocks or hot fund or hot asset class, and they keep failing," Krance says. "If we just told our story, some of these magazines would go out of business. Nobody wants to hear it; they want to hear how to beat the market."

R. Scott Maxwell, president of R. Scott Maxwell Financial in Dallas, says pain avoidance and a desire for certainty drives investors to seek "the elusive pill or insight that no one else has."

The randomness of the markets offers a perfect backdrop for pundits or asset managers to seem wise, even if they are only looking in the rearview mirror, Maxwell says.

"People are hungry for clarity when there is so much uncertainty, and so many of them have had bad experiences because of that uncertainty," he says. "They're seeking a way to know more, or to get an edge, because that's what the industry tells them every single day: Somebody is smart enough to know how to figure it out, and you just have to find them."

It doesn't help matters, Maxwell adds, that investors tend to second-guess their previous financial decisions. He says, "When you turn on the TV or pick up the newspaper, the daily narrative is, 'What should you have done yesterday?'"

In the end, Becker says, a portfolio is a vehicle to finance a life that investors envision and enjoy.

"The only reason money has value is because it gives us the freedom to spend our time doing things that make us happy," he says. "So for an investor, the important variables are what you're working towards, how much money you need to reach those goals and when you want to reach them. As long as your investment plan helps you reach those personal goals along your desired timeline, there's really nothing else that matters."