Modern folklore: ‘You, too, can beat the market’

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The past five years have been good for Jin Won Choi's investment portfolio. Mr. Choi, founder of MoneyGeek Inc., an Internet startup that offers tools and resources for young investors, says he realized a 25-per-cent average return on his investments over this period.

That's better than what market benchmarks such as the S&P/TSX have delivered historically, even in bull cycles.

"I'm a value investor, so I pick value stocks, and I've gotten a lot higher returns on my portfolio," says London, Ont.-based Mr. Choi, who worked for about two years as a hedge fund analyst before launching his own venture. "I'm definitely beating the TSX, which has had an average return of something like 14 per cent over the past five years."

The prevailing wisdom among most investors – and those who guide them – is that only those who are very lucky or willing to take extra risks can consistently outperform the market. But there is a vocal minority – made up of individual investors such as Mr. Choi, fund managers and advisers – who say picking the right stocks and making smart buy-or-sell decisions can consistently yield higher-than-market returns.

Numerous blogs and articles talk about why and how it's possible to do better than the market. Faced with these inspiring stories, some investors start to wonder whether they, too, should adopt a trounce-the-market mindset, says Brian Himmelman, president of Himmelman & Associates Financial Advisors Inc., in Halifax.

"There's been a tremendous amount of media and online information around beating the market over the last 10 years," he says. "The stories are repeated so much that it's almost folklore."

So should investors heed the folklore and try their luck?

Sure – if they're willing to take the risk that their quest for stellar returns may end up moving them away from their financial and life goals, says Dylan Reece, senior adviser and associate portfolio manager at Nicola Wealth Management in Vancouver.

"For an investor who knows what they want to achieve with their investments, market returns are not always the ultimate goal," says Mr. Reece.

"That's why it's important to articulate what your objectives are. Then, from there, determine the minimum real rate of return you'll need to meet your objectives, and the best strategy for achieving that return with the least possible risk."

Mr. Reece says he usually creates three investment strategies for his clients: one to address goals for the next 12 months, another to cover the following two to five years, and a third strategy for the period beyond.

A client with big expenses coming up within the year would probably be better off with low-risk investments, says Mr. Reece. But if the funds are likely to remain untouched for the next 20 to 30 years, then the portfolio can withstand higher-risk, more volatile investments.

"We use computer modeling to create these strategies, and more often than not we are able to tell a client that they don't really need as high an investment return as they first thought to achieve their goal," says Mr. Reece.

What's important to keep in mind, however, is that "just because you can tolerate a higher risk or, conversely, because you can afford to accept a lower return doesn't necessarily mean you should. Nor should you take excessive risks in hopes of outperforming the market."

Shannon Dalziel, an investment adviser with PWL Capital Inc. in Toronto, says investors looking to beat the market can get too caught up in their returns and fail to take into account factors such as transaction fees and taxes, which could translate into a lower overall return rate.

This approach can also turn investing into an abstract exercise, instead of one tied directly to personal financial goals, Ms. Dalziel says.

"The bottom line is that it is a riskier approach altogether, and a lot of research proves it's not likely to add value," she says.

Robert Broad, vice-president and investment counsellor at T.E. Wealth in Toronto, says novice investors working for the first time with an investment adviser will sometimes think they're hiring an expert to beat the market.

"Whether or not your adviser can actually do that, beating the market should be last among the investment decisions you need to make," he says. "Instead, you should be making decisions about what you're aiming for, what you're comfortable with in terms of risks and returns, and then come up with the asset allocation for your portfolio."

Once investors have structured their portfolio, they can then decide whether they're happy to accept market returns or they would like to aim higher, Mr. Broad says. The latter will typically mean higher management fees, which should be factored into the equation.

For those intent on chasing higher-than-market returns, Mr. Himmelman at Himmelman & Associates offers this advice: Don't get obsessed with year-by-year results.

"If you do decide to beat the market and have a logical and intelligent strategy, then you should stay with it for a certain period," he says. "But if you keep comparing your returns on a year-by-year basis, you could end up abandoning your strategy in a very short period of time."

Mr. Choi agrees. Beating the market, he says, requires patience and diligence. Contrary to some of the headlines out there, there's no quick and easy path to top-notch returns.

"Take the long-term approach, build up to it," he says. "With each stock decision, ask yourself: Are you comfortable holding this stock for three years no matter what happens? That forces you to think about the long-term prospect."

Expect to do a lot of studying and research, Mr. Choi says, and be prepared to swallow losses in the first couple of years.

"It takes a lot of time, especially in the beginning," he says. "You need to understand accounting, economics and a lot of industry jargon, and you need to expect to make a lot of mistakes in the beginning – it can be brutal."