Indeed, there are two real questions that need to be addressed before we can define the problem. First, what is the market? Second, what does it mean to beat it?
Let’s start with the market. We use the term loosely in general discussion, but here we need to be more precise. Are we talking about the stock market? In this case, yes, but that doesn’t completely answer the question. We need to ask whether we are talking about the U.S. stock market, international market, or global market. If the U.S. market, which index are we talking about? The Dow, the S&P 500, the Nasdaq—or something else? What market are we trying to beat?
These details matter for two reasons. First, different markets behave differently, so we need different strategies to try to beat them. Second, to beat something, we must know how to measure it—which means we have to pick something to measure. A consistent basis for measurement (i.e., a benchmark) is a key for determining success or failure. It is how any portfolio manager measures his or her performance, and the selection of an appropriate benchmark can actually help determine that success or failure.
In my case, I am going to use the S&P 500 as the benchmark. It is a widely known index, is reasonably representative of the U.S. markets and economy as a whole, and has easily available data.
It also works well when you look below the surface. It is made up of large companies, with liquid trading, so it is easily investable. There are multiple ways to invest in the index as a whole or in pieces of it. In other words, it is not only a good benchmark but also has a very good tool chest available to investors. It is not perfect, but it is better than any of the alternatives. So, that is what I will be using as my definition of the market that I want to beat.
What do I mean, though, by beating the market? There are three major components here: time, risk, and return. The last seems quite clear—with returns, more is better than less. But that idea holds true only if the other two factors are held constant. Our targeted returns are, by definition, higher than those of the S&P 500. But we have to accomplish that target while keeping risk—in the form of variance and drawdown—consistent with the index as a whole and over the same time frames that the index operates under. In other words, we can’t juice our returns by taking lots more risk or extending our time frames because that would be cheating.
In the next post, I will give some examples of what that cheating would look like and why we don’t want to do it. For the moment, though, we have a good first crack at the correct definition of the problem: we are going to try to generate higher returns than the S&P 500, with no more risk, over the typical time horizons for an individual investor. It sounds much easier than it is.