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Financial Opinion and Insights

Underperform the Market and STILL Beat It?

The Independent Financial GroupJim Lorenzen, CFP®, AIF®

What?  Never beat the market and STILL end-up outperforming it? 

Could that be possible?

If you watch enough tv or read enough articles, blogs, newsletters and e-letters, you’ll soon easily conclude that the two most important investment concepts seem to revolve around one of two basic concepts: Outperforming the market and/or limiting expenses.

What if they’re both wrong?

While I’ve never promoted the idea of trying to outperform the market, I have often talked about controlling expenses.  After all, it’s logical, isn’t it?   Any money you save on expenses goes into your pocket!   Not rocket science.

But, what if I’ve been wrong, too?

What if we’ve all been looking at the wrong things?

What if all the financial advisors – the ones who’ve been talking about managing risk and limiting the downside – actually have been telling everyone the little-known secret:  It’s maybe about limiting `downside capture’!

Let’s take an example and, just too keep our comparison of performance outcomes `apples to apples’, we’ll make all expenses equal at zero.

The following hypothetical example reflects a fictional market return showing 20% swings each year over a ten year period and what would have happened to Portfolio A, which invested $100,000 in ‘the market’.  As you can see, even though 6 of the 10 years were ‘up’ years, including both the first and last year, and even though 3 of the last 4 years were ‘up’ years, the market portfolio achieved an annualized return of only 2.12% and a gain of only $22,306. 

What’s interesting is what happened in portfolio B!    Portfolio B’s management emphasis was not on beating the market.  In fact, during the ‘up years’ it underperformed the market by 20% each time!   But, while the managers captured only 80% of the upside, they were successful in capturing only 70% of the downside.    How important was limiting the downside?   Take a look!

Interesting!   Now this is a hypothetical mathematical excercise, to be sure; but, it does illustrate the importance of managing risk and how unimportant ‘beating the index’ actually is!   It also demonstrates another important principle:  While it’s important to limit expenses, you don’t want to get caught in a ‘race to the bottom’.  Managers who know how to ‘optimize’ portfolio performance just might be worth what they’re paid.

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Jim Lorenzen, CFP®, AIF®Jim Lorenzen is a Certified Financial Planner® and An Accredited Investment Fiduciary® in his 21st year of private practice as Founding Principal of The Independent Financial Group, a fee-only registered investment advisor with clients located in New York, Florida, and California.  IFG provides investment and fiduciary consulting to retirement plan sponsors and selected individual investors.  IFG does not sell products, earn commissions, or accept any third-party compensation or incentives of any description.  Nothing contained in this material is intended to constitute legal, tax, securities, or investment advice, nor an opinion regarding the appropriateness of any investment to the individual reader.  The general information provided should not be acted upon without obtaining specific legal, tax, and investment advice from an appropriate licensed professional. 

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IFG does not sell products, earn commissions, or accept any third-party compensation or incentives of any description.  IFG does not provide legal or tax advice and nothing contained herein should be construed as  securities  or investment advice, nor an opinion regarding the appropriateness of any investment to the individual reader.  The general information provided should not be acted upon without obtaining specific legal, tax, and investment advice from an appropriate licensed professional.  The Independent Financial Group does not sell financial products or securities and nothing contained herein is an offer or recommendation to purchase any security or the services of any person or organization.