Beating the Market: Is Not a Financial Plan

When useful theories become commandments

This article began with a wide-ranging conversation with investor and author Robert Hagstrom. Hagstrom is sharply critical of modern portfolio theory, benchmark-aware investing and the value-investing establishment. His most useful point is not that every academic framework is wrong. It is that investment practice becomes distorted when a convenient measurement starts governing behaviour.

A fund manager assessed against an index every quarter will naturally worry about looking too different from it. The institutional pressure is towards a peculiar compromise: depart enough to justify an active fee, but not enough to become commercially unemployable after two uncomfortable years.

This helps explain closet indexing and some of the structural difficulties faced by active managers. It does not prove that a concentrated portfolio is better, or that tracking error should be ignored. Our article on active and passive investing deals with that evidence more fully.

The broader lesson is more interesting. Models shape behaviour. Once a measure becomes a target, people start managing the measure.

That is as true of investors as it is of fund managers.

What Markowitz actually solved

Modern portfolio theory is often caricatured as the moment finance decided that risk and volatility were the same thing. Hagstrom’s criticism contains a fair challenge, but the history is more thoughtful than the caricature.

In Harry Markowitz’s own account, he describes reading John Burr Williams on valuing shares by discounting future dividends. If an investor simply maximised expected return, Markowitz realised, the logical portfolio would place everything in the security with the highest expected return. Common sense and investment practice suggested otherwise: investors diversified because the future was uncertain.

His contribution was to show how expected returns, variances and relationships between securities could be considered at portfolio level. Combining assets that behaved differently could reduce the variability of the whole portfolio without necessarily sacrificing expected return. That was a real advance.

It did not value businesses, define every fluctuation as permanent economic loss, or tell a family whether its capital could sustain decades of inflation-linked withdrawals.

Criticising Markowitz for not solving those problems is like criticising a map because it does not tell you why you are travelling. The map remains useful. It simply should not choose the destination.

Volatility is neither irrelevant nor the whole story

Volatility measures how widely returns move around an average. It is observable, comparable and mathematically convenient, making it a useful proxy for uncertainty—but not a complete definition of risk.

A share price can fall while the business continues to strengthen. A smooth-looking investment can conceal weak liquidity, stale pricing or permanent economic deterioration. Cash can appear stable while losing purchasing power to inflation.

“Volatility is not risk” can itself become another commandment. Volatility matters when it collides with real life: when withdrawals or leverage force a sale, a short horizon leaves no time to recover, or discomfort prompts an investor to abandon the strategy.

Consider two people holding the same diversified growth portfolio through the same market fall.

The first is 42, still earning and contributing every month. Lower prices allow new contributions to buy more assets. Provided the time horizon and circumstances remain intact, the decline need not cause permanent damage.

The second is 72 and drawing a monthly income from the portfolio. Withdrawals continue while asset prices are depressed, so more units must be sold to fund the same spending. Even if markets later recover, those sold units no longer participate. The sequence of returns has changed the outcome.

Same portfolio. Same market. Different risk.

We explore these distinctions more fully in Investment Risk and Return and Best Balanced Funds for Retirees.

Behaviour adds another layer. Prospect theory is often reduced to the line that losses hurt roughly twice as much as equivalent gains please us. That is a useful shorthand, not a psychological law applying identically to every person and decision. The original theory dates to 1979, and later research has had to examine how experimental findings translate into economic life. The American Economic Association’s review is a helpful reminder of that context.

The practical point survives: a temporary fall can become a permanent loss when behaviour intervenes. Our article on the psychology of wealth and investing deals with that problem directly.

When a valuation label replaces valuation

“Value investing” has suffered a similar fate. A broad philosophy—pay less than an asset is worth—was gradually compressed into a style label and a handful of accounting ratios.

Low price-to-book. Low price-to-earnings. High dividend yield. Cheap.

These measures may identify candidates for analysis. They are not substitutes for valuation. In his 2025 examination of market data, Professor Aswath Damodaran argues that price-to-book has become less meaningful as intangible investment has grown and accounting has struggled to reflect it. He also questions whether the historical mean reversion underpinning some mechanical value strategies remains as dependable in an economy shaped by disruption and globalisation.

His criticism of active management follows naturally: if a low-multiple screen can be reproduced cheaply, what exactly is the active fee buying?

Damodaran’s deeper point is not that price no longer matters. Cheapness and value are not the same thing. A poor business may deserve a low multiple; a wonderful business can be a poor investment if its price assumes too much. As he demonstrates in a back-to-basics explanation, company quality and investment attractiveness depend on different questions.

We have already developed this argument in The Brilliant People With Broken Compasses. The point here is narrower: a ratio becomes dangerous when it stops prompting analysis and starts replacing it.

Concentration proves distinctiveness, not skill

Hagstrom makes a powerful case for focus investing. If an active portfolio looks much like an index, there is little reason to expect a different result before fees—and still less reason after them.

Genuine active management therefore requires difference: owning securities in different weights, omitting some large index constituents and accepting uncomfortable relative performance. But difference is not evidence of skill.

A concentrated portfolio allows its best ideas to matter. It also increases the damage if the analysis is wrong, an unforeseen event overwhelms the thesis, or apparently independent positions share the same hidden risk.

Concentration proves conviction and distinctiveness. Only a sound process, good judgement and results assessed over an appropriate period can begin to establish whether that conviction was justified.

Diversification accepts that the future is difficult to forecast and limits the damage from any single error. Too much can dilute insight into expensive mediocrity. Too little can turn an avoidable mistake into permanent loss.

The sensible balance depends on the portfolio’s purpose, the opportunity set, the investor’s capacity for loss and the consequences of being wrong.

A benchmark is an accountability tool, not a life goal

Benchmarks ask whether an investment approach added value relative to a sensible alternative. Without them, almost any result can sound impressive. A 10% return is less impressive if a comparable low-cost index earned 15%, and an active manager should not be rewarded for market exposure that could have been bought more cheaply.

Benchmarks help identify closet indexing, assess fees and separate market returns from manager decisions. They are essential to investment governance. They still do not tell an investor whether the financial plan is working.

That requires a different hierarchy:

These measures are not rivals. They sit at different levels of the problem.

The risks investors actually live with

For a real person, risk rarely arrives as a standard deviation. It arrives as an unwanted decision.

Can I retire when I planned to? Can the portfolio continue paying an income after a poor first five years? Is enough capital accessible if the business or family needs it? Am I relying on one company, one country, one currency or one favourable sequence of events? What happens if inflation remains higher than expected? Will I stay invested when the strategy looks wrong for longer than feels reasonable?

These are failure risks. For an accumulator, failure may come from saving too little or repeatedly interrupting compounding. For a retiree, an acceptable average return can still fail if poor returns arrive early while withdrawals continue. For a family with wealth concentrated in a business or single share, the investment portfolio may appear diversified while the family balance sheet is not.

For almost everyone, behaviour is a multiplier. A strategy that works only if its owner behaves like a spreadsheet is not yet complete.

A better hierarchy for investment decisions

The portfolio should begin with the financial plan, not the league table.

1. Determine the return the plan actually requires

What real return—after relevant fees and tax assumptions—is needed to support the spending, contributions, time horizon and capital goals?

This is not an invitation to choose an ambitious target. If the plan requires an implausibly high return, the answer may be to save more, spend less, work longer or change a goal’s timing. A portfolio cannot repair an impossible cash-flow equation without taking risks that may make failure more likely.

Planning may calculate a cash-flow-based internal rate of return. It should not be confused with a fund’s time-weighted performance or an inflation-plus objective; they answer different questions.

2. Identify how the plan could fail

The risks may include insufficient return, inflation, permanent impairment, sequence risk, inadequate liquidity, concentration, excessive fees, tax drag or behaviour. Their importance differs from one person to the next, which is why one universal risk score is inadequate.

3. Build for the required return and the relevant risks

Only then should asset allocation and implementation be chosen. The portfolio needs enough growth to make the plan credible, enough resilience to survive adverse periods and enough liquidity to prevent forced selling.

The objective is neither the highest possible return nor the lowest volatility. It is a return sufficient for the plan, earned through risks the investor can financially and behaviourally sustain.

4. Judge implementation honestly

Once the planning objective is clear, benchmarks resume their proper role. Managers, funds and portfolio structures should be compared with appropriate passive alternatives, after fees and with regard for the risks taken.

Active management should be genuinely active and offer a credible reason for its additional cost. Otherwise, a low-cost index is a difficult opponent to beat.

5. Measure the client outcome as well as the portfolio

Portfolio performance matters, but the final test is broader. Is the required return still reasonable? Are cash flows tracking the plan? Have goals or time horizons changed? Can the investor still live with the portfolio?

A benchmark can evaluate the engine. It cannot tell you whether you are driving to the right place.