Is constructing a portfolio just another way to beat the market?

[thai_tong]

We never stop hearing about S&P500, it's so standard in FIRE communities. Rather than trying to beat the market by timing trades on hand-picked shares it's more effective to just buy an index fund for the S&P500.

In the same way I'm starting to think that almost any advice for constructing a portfolio is a different version of trying to beat the market. Recently I bought an index fund for consumer staples because I thought it would do better in an economic downturn but maybe I'm just trying to beat the market by avoiding risk. I could be better off purchasing more S&P500 funds and bearing the risk.

Constructing a portfolio to minimize taxes paid makes sense because taxes are definite, there's no speculation. Everything else seems like another way to beat the market. Is this way of thinking correct or am I missing something big?

[FBeyer]

Psychology. Do you trust your portfolio? Are you happy with accumulation or do you build for cash flow? Dislike variance? Whatever... I didn’t build a dividend/value portfolio because I want to beat anything, I did so because I TRUST my picks. I’d rather have 20 quirky buddies I chosen as friends for myself than finding ALL my friends at the dance school

[unemployable]

You're not wrong.

Yes, you are choosing to concentrate in a specific sector at a specific time. You wouldn't have done that if you didn't think consumer staples would probably beat the broad stock market over the next few years.

That said, the concept of a "market portfolio" could be much better defined, especially on the scale of ERE-wealth investors. Most of the discussion in this regard is with portfolios at the billion-dollar level, like pension funds and endowments. Most larger individual investors (hundreds of millions or billions) have some concentration in the asset that generated the original wealth, typically company stock or real estate.

No one really agrees what the US/international/bond/real estate/etc breakdown "should" be, or even what index to use. You mentioned SPX, which is the most accessible and tradeable one out there, but VTSAX (the underlying index, not necessarily the mutual fund) has its adherents, and most people used the DJIA before the 1980s or so.

Everyone "constructs" a portfolio one way or 'tother. If you go 60/40 that's not 85/15 or 100/0. If you buy a house in Dallas you're concentrated in the Dallas real estate market. If you work at Walmart you have concentrated exposure to Walmart and to B&M retail. Just like Sam Walton's kids!

The theory says what it says, but your guesses aren't much worse than anyone else's. The people who rent out entire floors in midtown Manhattan skyscrapers often get it spectacularly wrong.

[slowtraveler]

No. But the market isn't difficult to beat with a large enough capital base and disciplined behavior if that's your goal. Removing the adjustment for float and buying the components directly would almost certainly win over a long period of time.

I use a modified Golden Butterfly portfolio. The expected return is above the S&P but the main benefit to me is the low drawdown length & intensity (ulcer index) coupled with strong returns. 24/24/24/24/4 is a good portfolio with strong returns, much lower risk, and all you do is rebalance once a year to get your 4% withdrawal out.

[oldbeyond]

To completely implement the passive strategy of “buying the market”, one would choose something along the lines of the GFAP (all financial assets by market cap): https://www.pragcap.com/is-the-global-f ... -strategy/

He makes some assumptions and simplifications, but it’s likely a decent attempt. Most people are overweight equity, especially domestic, and underweight foreign bonds. I think that might be wise, but it is an “active” decision. It’s amusing to see people being dogmatic about buying the market, and then overweighting the US because it’s performed better historically We all try to beat the market.

[IlliniDave]

It gets pretty impractical when the definition of "market" extends to the collection of everything in the world a person could use to preserve or grow their wealth. Originally, in context, the term was coined by US stock investors to refer to all the issues available on the NYSE. Historically the value of the SP500 index was used as a measure of the movement of the market's value and as such became the standard against which stock mutual funds were measured. Later two things happened: people got the idea to construct a mutual fund that imitated the construction of the SP500 index and would track its value, and it became easy for US investors to invest in non-US equities (and later non-US bonds) via mutual funds available in the US. Some people have extended the definition of market to include all stocks worldwide, others have extended it to include all stocks and bonds worldwide. The further one casts the net in defining the market, the less applicable and oftentimes practical ideas borrowed from the original proponents of passive investing get, IMO, as they become further taken out of context.

And yes, there is no such thing as 100% passive investing if you want to pull out your dictionary and audit the process. Simply deciding to invest at all could be classified as a foul. Deciding to invest passively would be a foul. I classify myself as a passive investor mainly because my core philosophy is buy/hold. But I still have an overarching plan that changes how much of what I hold through time to match what I anticipate my life's circumstances to be. So every now and again I rebalance, and I tax loss harvest when I can. I would argue that doing things like adjusting the components (e.g., stocks versus bonds versus cash, etc.) of one's portfolio to stay in line with one's financial situation and risk tolerances (non-static items) is not an "active bet" on anything.

It is better to think of advice for constructing a portfolio when it comes from someone like the late Jack Bogle or his contemporaries in the passive investing movement, or the most traditional among the bogleheads and similar communities, not as putting together a portfolio designed to beat the market, but rather as putting together a portfolio to efficiently support one's lifelong financial goals.

[arcyallen]

... but rather as putting together a portfolio to efficiently support one's lifelong financial goals.

Exactly. What are you goals? That's all it comes down to. The FIRE community is so caught up with VTSAX! VTSAX! that rarely anyone stops to ask "Is this actually appropriate for me, or the person I'm emphatically recommending it to?" Maybe some specifically want dividend income. Maybe you want lower volatility, because the next 50% market drop will make you poop your pants (in the FIRE community this will be very entertaining at the next drop). Or you hate a certain industry. Everyone is different. I like maximum return and volatility bothers me zero, so I own a handful of active funds and some stocks I've bought on occasion generally when they got stupid cheap. I'm not necessarily trying to beat the market, but I am a fan of buying extra cheap When the market dipped down below 7000 I was considering selling my convertible to invest. Most people were too busy pants pooping.

[Dream of Freedom]

It is hard to think that someone shoving money into a 401k because they heard it was a good idea is putting much thought into beating the market.
What about the people who run the funds they invest in? Surely they are trying to beat the market right? Well they get paid based of how much money is in the fund not directly off of returns. So they could increase the size of the fund by busting butt or by simply hanging out at the country club with people who have tons to invest. Additionally they often have to take extra risk to try to get return. But they don't have ultimate control of the money invested in the fund. So when the fund goes down people take money out. But they can lower the amount it goes down and save their jobs if they invest in less risky things like bonds.
So does that mean Boggle was right? I don't know, but indexes are not without flaws themselves. For example they are buying more of what is expensive and less of what is cheap. This is because they base how much to own off of market cap.

[Scott 2]

Constructing an indexed portfolio is choosing the amount of risk you want to take in the market, via asset allocation. The market has an expected return for that risk. The price of higher return is increased risk, also expressed as increased volitality. Putting uncorrelated asset classes in the portfolio reduces that volitality, increasing expected return for the same amount of chosen risk.

None of that, to me, is trying to beat the market. You can commit to buying an asset allocation and blindly execute. Throwing all your pile on VTSAX is a very naive execution of this strategy. Historically it works great in bull markets, but they'll be hammered during a downturn.

Blending domestic stocks and bonds is somewhat less naive. Eventually, more asset diversity falls to reduce risk for an expected level of return, meaning your portfolio is sufficiently diverse.

My 401k offers investment options that use volitality targets to buy index funds. There's some fancy math involved, but no stock picking. The resulting asset allocations aren't too far off a Vanguard target retirement fund.


When someone starts trying to identify assets that are undervalued to buy, or overvalued to sell, they begin trying to beat the market. This could be done picking index funds, fluctuating asset allocation as the market fluctuates. More foreign stocks today, more US stocks in two months. It could be done evaluating individual stocks, trying to pick a winner. Both are examples of what (educated) people are talking about, when they say you can't beat the market.

[Tyler9000]

We never stop hearing about S&P500, it's so standard in FIRE communities.

The dirty little secret of the popular FIRE community is that the S&P500 is the standard investing advice not because it is the best choice for early retirees or because it actually represents "the market" as a whole but simply because the data is easily accessible to study. It's a classic example of data availability bias that created an extremely strong anchoring bias that permeates most investing research you'll find.

Rather than just "buying the S&P500 and bearing the risk", a properly constructed portfolio is able to meet your financial goals consistently and without worry. It's not about beating the market. It's about intelligently investing in multiple markets in a mutually reinforcing way. Think of it as baking a loaf of bread out of a few staple ingredients instead of solely living on a diet of nothing but flour.

Sorta along these lines, you might find my most recent article interesting: When Aiming for a Target Consider the Accuracy of the Weapon. TL;DR -- not every portfolio is equally unpredictable, and the S&P500 isn't necessarily the best choice to reach your financial goals

[jacob]

Did you mean precision?

Precision is the spread (variability) of the bullet impacts usually measured in minutes of angle. It's the opposite of uncertainty.
Accuracy measures the difference between the aiming point and the average impact point. It's the opposite of being off or wrong.

The accuracy can be measured by firing lots of bullets(*) because the uncertainty decreases by 1/sqrt(n) with the number of measurements. Repeating an experiment can make up for lack of precision. However, no matter how much the experiment is repeated, it can not fix a lack of accuracy.

(*) Insofar the conditions are repeatable. A cold barrel shoots differently than a hot one. In investing, there are more variables. The most common on to correct for is P/E (see e.g. Shiller's work on the correlation between P/E and subsequent returns which at peaks at 18 years at about 0.6.). A hot market shoots differently than a cold one.

[Tyler9000]

Just my luck to use a shooting metaphor with an audience that includes a scientist who actually shoots. I'll stick to Nerf.

I chose the term "accuracy" to follow the same terminology in the video and because my goal is to communicate the error relative to expectations rather than the precision of the measurement. But your point is well taken, and of course you're technically correct. Even something like the Golden Butterfly can be very precise but highly inaccurate if your laser sight is set to the average return with no inflation.