I recently came back from an ETF conference in Florida where I participated in two panel discussions and sat in on various others. One recurring phrase during the conference was: "You can't consistently beat the market."

I think this statement needs some qualification. It's too limited, and the definition of "the market" is very subjective. And who is the statement referring to? Who's the "you"?

I believe that the market is and can be beaten on a consistent basis. The problem is identifying how and by whom.

What Is the Market?

Everyone has his or her own definition of "the market." Most people over the age of 50 are likely to see the market through the perspective of the Dow Jones Industrial Average. Younger investors might be inclined to gauge the market from the returns of the S&P 500, Nasdaq 100 or perhaps the Russell 200. Some global money managers will target their returns vs. a global index such as the Morgan Stanley Cap International World Index, which is a product of MSCI Barra ( MXB) Even market participants investing in the same asset class won't necessarily target the same benchmark.

At the end of the day, whether you're an individual investor or a professional money manager, we should all find a benchmark to measure our performance against. There is one caveat: For a given portfolio or strategy, one should consistently target the same index.

Who Are You?

When market commentators say you can't beat the market, sometimes this is their way of telling the individual investor that they might be better off having their money professionally managed. Sure, there are plenty of how-to books on investing, but at the end of the day, ask yourself this series of questions: Would you remove your own appendix if you had appendicitis? Would you drill your own tooth and fill a cavity? Would you represent yourself in criminal court? Chances are you wouldn't. So do you want to manage your own investments?

Say that investment results are distributed normally around a mean of 10%, with a standard deviation of 2%. The mean return is equal to the "market" return. This distribution is depicted in the chart below.

As we can see, an most of the returns fall between the green lines, within +/-1 standard deviation (+/-2%) of the mean for our fictitious market's results, which are normally distributed. Keep in mind that many people will perform outside of the green lines. Some will outperform the market by a standard deviation of more than 1, while others will underperform the market by a standard deviation of less than 1.

Those who outperform are grabbing their excess performance from those who underperform. Whether it is as a result of bad timing or poor decision-making, underperformers exist. Investment professionals are hoping that individuals are the underperformers, because they are trying to sell their out performance and receive a fee for it.

There is nothing wrong with that. In fact, as a professional money manager, I seek to perform my services for individuals who cannot do as well for themselves. If a professional consistently underperforms, then he or she will lose assets and might not survive as an investment manager. Thus, over long periods of time, natural selection will weed out poor professionals and allow the consistent outperformers to dominate.

How Can You Overperform?

I contend that too much time is being spent on stock selection. Not enough time is spent on stock rejection. As investors, we are expected to select stocks that will outperform the market, and we spend far too much time and effort on doing so. Our time is better spent on eliminating or rejecting stocks that will underperform.

For example, suppose we have a simplistic market of five stocks: A, B, C, D and E. On average, the return for all five stocks will equal the market return. However, if we can identify which one or two of these stocks will underperform and exclude these stocks from our portfolio, then we will almost certainly outperform the market.

We also have to be careful not to make selection or rejection errors. In statistics, there are two types of errors that can occur in the decision process:

  • Type I: Statistically speaking, this is a rejection of the null hypothesis when the null hypothesis is true. In layman's terms, this is what we call a false positive. We accept something that is incorrect. A type I error occurs in investing when we accept an investment that will perform poorly. This is a more costly error to investors. Clearly, we want to avoid Type I errors.
  • Type II: Statistically speaking, this is a failure to reject the null hypothesis when the null hypothesis is false. In layman's terms, this is what we call a false negative. We reject something that is correct. A type I error occurs in investing when we reject an investment that will outperform the market. Type II errors are more difficult to avoid and tend to be less costly. Nevertheless, we want to avoid type II errors if possible.

Homework

  1. Carefully define your benchmark and asset class when developing an investment strategy. Manage that portfolio within the context of the benchmark selected.
  2. If you cannot on a consistent basis outperform the market, then you might be best served by hiring a professional to do so for you.
  3. Try to deselect underperforming investments and avoid type I errors.

At the time of publication, Rothbort had no positions in stocks mentioned, although positions can change at any time.

Scott Rothbort has over 20 years of experience in the financial services industry. In 2002, Rothbort founded LakeView Asset Management, LLC, a registered investment advisor based in Millburn, N.J., which offers customized individually managed separate accounts, including proprietary long/short strategies to its high net worth clientele. He also is the founder and manager of the social networking educational Web site TheFinanceProfessor.com.

Immediately prior to that, Rothbort worked at Merrill Lynch for 10 years, where he was instrumental in building the global equity derivative business and managed the global equity swap business from its inception. Rothbort previously held international assignments in Tokyo, Hong Kong and London while working for Morgan Stanley and County NatWest Securities.

Rothbort holds an MBA in finance and international business from the Stern School of Business of New York University and a BS in economics and accounting from the Wharton School of Business of the University of Pennsylvania. He is a Term Professor of Finance and the Chief Market Strategist for the Stillman School of Business of Seton Hall University.

For more information about Scott Rothbort and LakeView Asset Management, LLC, visit the company's Web site at www.lakeviewasset.com. Scott appreciates your feedback; click here to send him an email.

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