'Beating' the Market Not A Sound Financial Strategy

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Posted: Mar 19, 2009 12:01 AM
'Beating' the Market Not A Sound Financial Strategy

Body text: When people seek investments, they tend to have one goal in mind: They want to beat the market.

Don't agree? Then tell me why you compare the performance of your investments with Standard & Poor's 500 Index. You're gauging your success by comparing your investment results with the overall market, as measured by the S&P 500, the Dow Jones Industrial Average, or some other index. If you're beating the market, you're happy. If you're not, you're unhappy.

Guess what? Trying to beat the market is the wrong goal. In fact, that is a disastrous goal. Taking that approach may set you up for failure, as I point out in my new book "Rescue Your Money" (Simon & Schuster). The book, which is on sale nationwide, explains the mistakes, myths and major obstacles that prevent people from achieving financial success, and shows what you need to do get on the path to financial security.

So why does trying to beat the market set you up for failure? It's really very simple. And we need look no further back than 2008 to find a perfect example. In 2008, the S&P 500 lost 38.5 percent. If you lost only 30 percent, congratulations! You beat the market!

Somehow I doubt that you (or your spouse) would be thrilled at such news. Thus, we must remember that "beating the market" isn't the point. In fact, only one thing matters when it comes to investing: achieving financial security. That is your one major goal.

Think about it. The purpose of investing is to help you accomplish your goals, whether that means sending your kids to college, retiring comfortably, or caring for aging parents. It's financial security that matters, not some benchmark that has no relevance to your personal life. People who focus on the market are missing the point. You need to emphasize your goals. If financial security is the goal, you'll soon encounter a couple of problems. Let's explore them.

The first obstacle you'll encounter is taxes. When you earn money from your occupation, you pay income taxes. When you purchase goods, you pay sales taxes. If you invest money, you'll pay income taxes on the interest you earn or capital gains taxes on the dividends and profits. If you buy real estate (and in some jurisdictions, cars, boats and airplanes), you'll pay property taxes. If you give your money to family members, you (not them) might have to pay gift taxes. And if you should die with more money than Congress feels is appropriate, your estate will pay estate taxes.

As everyone who has accumulated money knows, money does not solve every problem. But it sure does create new ones.

The other obstacle to financial security is harder to notice (because you never actually write a check for it, like you do to the IRS), but it's just as damaging as taxes. Inflation has averaged 3.2 percent from 1926 through 2008, according to the U.S. Bureau of Labor Statistics. Sometimes it's higher, like from 1973 to 1974, when inflation averaged 8.6 percent. Other times it's quite low, as in 1998, when it was only 1.6 percent. But over long periods, it has been remarkably consistent at 3.2 percent.

The sad truth is that taxes and inflation most hurt the people who know the least about investing. Let's assume that you place $100,000 into a five-year bank certificate of deposit that pays 3.1 percent in interest annually. That's the average CD rate as of Dec. 31, 2008, according to Bankrate.com. If you earn 3.1 percent, you earn $3,100 in interest. Of course, you don't get to keep all that money because the interest is taxable.

Let's assume that you pay both federal and state income taxes. Let's further assume that your combined federal/state tax bracket is 30 percent. Since the CD paid 3.1 percent, you lose 0.93 percent to taxes, leaving you with a profit of 2.17 percent.

But let's not forget inflation. If inflation is averaging 3.2 percent, you're actually losing 1.03 percent on every dollar you invested in that CD. Now, losing 1.03 percent annually might not seem like much, considering that the S&P 500 lost 38.5 percent in 2008. But the stock market doesn't lose every year, while the CD does.

If you lose 1.03 percent every year for 20 years, guess what happens? You end up losing 20.6 percent of your money. In other words, if you start with $100,000, over 20 years you'll watch your money "grow" to $79,400 in real economic terms.

That's what happens when you plop the bulk of your money into low-yielding investments. You'll most likely go broke, and you'll do it safely.