Why Beating the Benchmark Isn’t Always the Best Investment Strategy

The Adani group is a point of discussion everywhere. Even if someone is not getting impacted by whatever has happened to this company, still to pass time one has to blame government, politics and who not for all this.

Such a discussion was happening in one Whatsapp group where my school friends were doing their bit and after sometime the chat moved from Adani to Investments. 

“See this is why I feel Investments is not a child’s play and one needs a professional advisor to manage the Investments. Afterall we are not experts.” Said one.

“But, we all know that nowadays no expert can beat the benchmark or Index, so what’s the role of a professional advisor in suggesting investments if one has to buy only an index.” Added another.

Post this, many others contributed by sharing their “Success” or “Smart Investor Stories”, as to how they bought the Nasdaq 100 Index when it fell, some said they are smarter by adding Tesla at the “Right” time. 

Just to add here that Most of my Schoolites are NRIs, and are Doctors or Engineers.

I did not participate in this discussion. There was nothing to contribute. If they think what they are doing is the best for them then be it. They know their lives and goals better. 

But later, one of them, who knows what i do, called me, shared her investment portfolio and specifically asked if her investments are beating the benchmark , as others were talking about. 

She was concerned if She is invested in the right products?

Now when someone asks me directly, it becomes my responsibility to guide the best I can. 

Investing is a crucial aspect of personal finance management. It provides an opportunity to grow your wealth and achieve financial stability. Investing is not just about earning returns; it’s a delicate balance between earning returns and managing risks.  

However, many investors tend to make a common mistake of focusing solely on beating the benchmark or index as the primary criteria for making investments. 

This narrow-minded approach can be detrimental to your investment portfolio and financial well-being in the long run. 

So with this one on one discussion, I tried to  explore why beating the benchmark is not always the best indicator of success and is not a good investment strategy, and why it is important to consider other factors, such as financial planning, risk management, and goal-based investing, in order to make informed investment decisions, and a Comprehensive Investment Plan.

First and foremost, it is important to understand that beating the benchmark is not always a guarantee of success. The benchmark represents the average performance of a group of stocks, and outperforming it means beating the average. Yes, I agree that many active funds are unable to beat even that average, but that’s what benchmarks are for. Would you like to keep the benchmark which gets beaten so easily that it loses its importance?

However, this is also true that  just because an investment outperforms the benchmark does not mean that it is a good investment. For example, a mutual fund that outperforms the benchmark could be due to the concentration of few stocks in the portfolio, which could in future also become the reason for future underperformance too. 

Indexes are made on the basis of Free Float market capitalisation, it does not look at the profitability, quality, and other fundamental factors. Thus stocks which even if overpriced, but are being traded in high volumes get their entry easily into the indexes. 

This is the reason when those stocks which are not good fundamentally, crash, taking the broader index along with it. 

(Please note : The NSE’s most popular market benchmark, the Nifty 50, already includes Adani Ports and SEZ and Adani Enterprises. Also, Adani Enterprises is part of Nifty 100 and Nifty 100 Liquid 15 Index.)

 Also, as a part of periodic review, it is expected that from March 31, Adani Wilmar will be part of Nifty Next 50 and Nifty 100 indices, while Adani Power will be included in Nifty 500, Nifty 200, Nifty Midcap 100, Nifty Midcap 150, Nifty LargeMidcap 250

Most Importantly, one needs to know that he doesn’t know. I mean, broad indexes are fine, but has one ever looked at hybrid indexes, debt indexes, or even sectoral indices, which also become the benchmark of few Investment strategies?

With limited knowledge or sticking to the general belief that a fund has to beat index , investors tend to focus solely on Nifty 50 or Sensex. But What if the Fund’s benchmark is Nifty Next 50 or Nifty 500 or anything which actually supports the objective of the Fund?

Moreover, when you design a Portfolio it should have a mix of different strategies of investment, and thus has to be balanced from the risk point of view too.  

One of the most important aspects of successful investing is financial planning. Financial planning involves identifying your financial goals and creating a plan to achieve them. 

This involves considering factors such as your current financial situation, risk tolerance, investment timeline, and future financial obligations. By taking these factors into account, you can create an investment portfolio that aligns with your financial goals and meets your unique needs.

For example, if you are a young professional with a long investment timeline, you may be able to afford to take on more risk in your investment portfolio. On the other hand, if you are closer to retirement, you may prefer to adopt a more conservative approach to investing, focusing on preserving your wealth rather than taking on unnecessary risk.

Risk management is another critical aspect of investing that is often overlooked when the focus is solely on beating the benchmark. 

While it is important to earn returns, it is equally important to manage risks and protect one’s investment portfolio from market volatility. This can be achieved through diversification, and Asset Allocation which involves spreading investments across different less correlated investments, Asset classes and Sectors to reduce the risk of losses in one area affecting the entire portfolio.

In Active Management, Fund houses have their Risk Management Strategy and when they are not comfortable with the valuations, they do not get into such stocks or Keep it in limits or exit fast. Active Managers have a dual job to play…generating returns with lesser Risk. and this Risk Management Part is normally Ignored by Investors.  

(Even on Returns side, do remember that Point to Point Returns, Rolling Returns and XIRR Vs Portfolio Returns will always be different, so you cannot be always sure that if the “funds in your portfolio” vs the “funds in general”, has beaten the benchmark or not) 

By focusing solely on outperforming the benchmark, an investor may overlook important factors that could impact their long-term financial wellbeing. 

Remember a Good and Seasonal Investor, always prefer a Stable , less volatile return which provides benefit of long term compounding. 

Furthermore, goal-based investing is a much more effective approach to investing than simply trying to beat the benchmark. 

Goal-based investing is a strategy that focuses on investing to achieve specific financial goals. This approach involves setting clear financial goals and choosing investments that are most likely to help you achieve them. 

For example, if you have a goal of saving for a down payment on a home, you may choose to invest in a fixed deposit or other low-risk investment that provides a stable return. 

On the other hand, if you have a long-term goal of saving for retirement, you may choose to invest in a mix of equities and bonds to take advantage of the potential for higher returns over the long term.

Conclusion:

See, the more people search a particular stock the less it will provide opportunities to make money from price variation and thus you can’t generate Alpha of it. 

This is what has started happening in Indian stock markets. When more and more Institutional Investors, Research houses, Mutual funds, Insurance companies are researching the limited set of stocks, it is getting difficult to beat the Broad Index. 

But the more you look at the investment benchmark, the farther you go from your own personal benchmark (your goals). You should better design your portfolio keeping your benchmark in mind and beat the same by designing a portfolio suitable to your Risk Tolerance, with a mix of Different Investment strategies and covers all market segments like Large, Mid and Small caps.  

Your Love for Index investing has led to a surge in Passive funds in recent times. Earlier this space was dominated by only broad index funds but nowadays you will find many complicated Smart beta funds too. All are trying to gain attention which is coming from your confusion and desire to get more and more.

If you really want to build wealth, Stay away from the Noise , have a focused investment strategy in place which is coming from your goals and risk tolerance, and let compounding take care of rest.