Castles built on quicksand.

Investment records that crush the market by a wide margin are incredibly tempting to potential investors. They look too good to be true, and frequently are.

Although I strongly believe beating the market is possible, doing so by a very wide margin is extremely difficult, and almost always means imprudent risks are or have been taken.

The best investor in the world, Warren Buffett, is said to have beat the market by around 10% a year over the last 60 years (taking into account both his personal and professional investments). That's incredible performance! A 10% return over 60 years would multiply your money 304 times; beating the market by 10%, providing a 20% annualized return over 60 years, would multiply your money 56,000 times! Buffett is the second richest man in the world because he's done something truly extraordinary.

So, when someone says they've beaten the market by anywhere close to 10% a year, you have to ask yourself if you're talking to the second coming of Warren Buffett, or someone building castles on quicksand.

Beating the market by anything close to 10% a year can be done, but most who've done so took incredibly high risk to get there. It may not seem that way when you talk to someone who's beaten the market by 8% a year for 15 years, at least not until their portfolio tanks by 60%. Making back a 60% loss requires a 250% gain, and that's very difficult to do without taking even more imprudent risks.

Why do I say beating the market by a wide margin requires taking imprudent risk? Just look at history.

Individual investors received 3% annualized returns while the mutual funds they invested in went up 12% a year (Dalbar study, 2003). Only around 45% of professional investors beat the market over rolling 5 year periods, and most of those 45% beat by less than 1% and can't do so consistently (Morningstar and Standard & Poors). Some of the best investing records in the business beat the market by a mere 3%+ annualized over long periods of time (I'm talking 20-30 years, not 3-5). Those in the business know how extraordinary 3% annualized out-performance is.

The way to beat the market is to invest differently than the market. That can be done in one of two ways: 1) prudently, with adequate diversification, or 2) imprudently, with highly skewed gambles and too much concentration.

Look at the records of investors that have blown up. They frequently had very long runs that look highly successful, until they blow up with 60%+ losses. It's like building a castle on quicksand: it looks good for a while, until it sinks into the muck.

When looking at investing records, it's more important to examine how the record was achieved than to focus exclusively on bottom line numbers.

Was the record generated over a long period of time, or was it less than 5 years? Were high returns due to a couple of lucky, out-sized bets, or a balanced portfolio that has edged up as a whole? Are returns due to a lot of investments over a long period of time, but all of those investments were in a single sector, like technology or financials? Can the investor non-defensively discuss their failures as well as successes?

If returns are over too short a period, or due to only a couple of out-sized bets, or focused in a narrow sector, or if the investor becomes overly defensive about how they generated results, you should be cautious. Those are warning signs.

I can't say all outstanding records are frauds, because there are Warren Buffetts out there. But, you better be certain you're talking to someone who really knows what they're doing, and you better be prepared to ask tough questions.

Or, you just might find yourself living in a castle built on quicksand, too.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.