We have been conditioned to believe that successful investors and savvy portfolio managers are the ones who “beat the market” by identifying the best stocks to own and the best times to own them. Movies like “Wall Street”, the 24-hour onslaught of CNBC, Money Magazine and the legend of the likes of Warren Buffet have all added to this conventional wisdom.
As a financial and investment advisor nearly every time I meet someone new and they learn what I do I am asked, “So, what do you think about the Market?” Implied in that question is the belief that, because I am an investment advisor, I have some special foreknowledge of future price movements of the stock markets.
This illustrates two critical misperceptions of the nature of investment advice and investing. The misconception being that investing is about Performance and Prognostication.
In fact, the real value of financial and investment advice lies in a focus on behavior. Clearly, in my twenty plus years of practice I have seen far more portfolios with investor problems than investors with portfolio problems.
The simplest, clearest and most compelling argument for the importance of behavior to successful investing is the annually updated comparison (by Lipper and DALBAR, Inc.) of the 20-year average annual compound rate of return of the average large company stocks (as measured by the S&P 500) in the U.S. and the average return realized by the average stock mutual fund investor. For the 20 years through 2010, these were:
| Average EquityFund | Average EquityFund Investor | |
|
9.14% |
3.83% |
This study is the only one I know that focuses in on Investor Performance rather than Investment Performance. And, while these numbers rise and fall from year to year, the relationship between them remains remarkably constant: over 20 year periods, the average mutual fund investor consistently manages to capture less than half of the return of the average fund.
How is it that, in a society obsessed with “performance,” the average investor not only underperforms the markets but also underperforms, by a whopping margin, his own investments?
What would the average investor have had to do over the past 20 years to have earned that 9.14% compounded average rate of return? Correct: they would have had to identify the most mundane, middle of the pack, so-so, large company stock fund, invested in it and chosen the dividend reinvestment option. And (here’s the key) left it alone for 20 years.
Of course, most people don’t do that. They do something else. Something else that had some combination of three important characteristics: (1) it was the wrong thing to do, (2) at the wrong time and (3) for the wrong reasons.
The reason average investors blew – and consistently blow – more than half of the return of the average fund over any 20-year period is that they behave inappropriately. Here is an incomplete list of the types of things the average investor did over the last 20 years to insure they didn’t get the returns the markets would have otherwise given them:
- He bought only funds with the hottest recent “performance.”
- When those previously hot funds inevitably lagged, he switched into the next crop of recent hot performers. (Use, rinse, repeat.)
- In October 1987, and/or October 1990, and/or August 1998, and/or October 2002, and/or February 2009 – that is, at any or all of the major market bottoms in the past 20 years, when stocks were the cheapest, he went to cash in a panic. In between, around 1999, he loaded up on tech, telecom, dot.com and other icons of a “new era.”
- He probably also did some online day trading for good measure.
The irony, of course, is that this behavior is “normal.” It is the behavior of the majority of investors being what defines normal. Clearly, this normal behavior is the enemy of every investor’s financial wellbeing. All of which begs the greater question: What are the behaviors and, even more important, the beliefs of successful investors? What does one need to believe and do in order to produce superior, long-term, real life returns from their investing efforts?
The answer will be in my next post.
Behavior: The Key to Investing Success – Part Two
There are three principle beliefs and three principle practices that characterize those who achieve a successful investment experience. This post will cover the beliefs.
The first and foremost principle is Faith In The Future. I believe that, ultimately, investing is an internal battle between faith in the future and fear of the future. And, over the course of a 40 years of accumulating assets during a working career followed by another 30 years of living off of those assets during retirement an investor’s lifetime return will largely be determined by which of these two impulses wins.
I’m not suggesting a Pollyannaish blind optimism or a mindlessly positive world-view in the absence of facts. What I’m saying is that faith in the future is the investor’s only point of view supported by the facts of the historical record. While it may be fashionable, pessimism is not only wrong but counterintuitive. No one examining the historical record over the past seven decades would arrive at the fundamental conclusion that the world is in decline.
There are many examples, but I’ll mention only two. The commoditization of miracles – that is, the almost instant progress of anything from breakthrough to commonplace – blinds us to the fact that human progress is not linear, but exponential. The common, everyday minivan you see all around you today contains more computing power than existed in the world in 1951 (when I was born). Further, in the next 25 years there will be another billion-fold increase in computing power per dollar thus solving ever more complex problems, further enhancing human productivity and quality of life.
In short, the successful investor says, “I may not know precisely how things will turn out all right; I just know things will turn out all right.”
The second principle of successful investing is Patience. We live in a time of instant distribution of data (masquerading as information). Instead of hearing enduring investment principles we are awash in a tsunami of late-breaking news.
All of this persuades us, even pressures us, into thinking that we must certainly have to do something – to react to the news of the moment – rather than to act on the goals of a lifetime. Yet the more often one changes one’s portfolio – there is, in fact, evidence that the more often one even looks at their portfolio – the lower their real-life return will be.
The decision to change a portfolio – even when long-term goals have not changed – is nearly always wrong and dampens returns. The decision to get out of the market with the intention of getting back in at a “better time” means the investor has to be right twice. Rarely is anyone so lucky. According to Warren Buffet, “The stock market is a highly efficient mechanism for transferring wealth from the impatient to the patient.”
Patience, then, is the decision not to do something wrong with a long-term, goal-focused portfolio and can be summarized this way. “I cannot know when things are going to turn out all right. I just know things will turn out all right.”
The third principle of successful investing is Discipline. Where patience is the decision not to do something wrong, patience is the decision to keep doing the right things.
It is all too common to see an investor stop a disciplined plan of regular contributions to their portfolio in the face of a declining market that feels like it is going to go one forever. When, in fact, an aversion to falling prices is the exact opposite of common sense. Someone who is regularly investing for their future should regard falling prices as a gift. The lower prices lower their average cost – allowing them to buy more and more shares with their same regular contribution – thus almost certainly enhancing their prospective real-life return.
Simply put, the disciplined investor says, “I do not care what’s working now. I care about what has always worked…and I am going to keep on doing what has always worked.”
The undisciplined investor reacts to every wind that blows. The disciplined investor continues to act no matter the terrors or the enthusiasms of the current moment.
Next time we will examine the practices.
Behavior: The Key to Investing Success – Part Three
The first practice of successful investing is Asset Allocation. The long-term mix of stock, bonds and cash is the primary determinant of the actual returns generated by a portfolio. This flies in the face of our culture, which maintains that what you own (selection) and when you bought it (timing) determines your portfolio return.
In the long run selection and timing have little to do with portfolio returns. Asset allocation, the mix, is of far greater importance. There are a number of studies on this, the best known is the 1986 paper “Determinants of Portfolio Performance” by Brinson, Hood and Beebower (Financial Analysts Journal, July/August 1986). They asserted that a portfolio’s static target asset allocation accounts for 93% of its variation in returns and volatility. The other 7% is from timing and selection.
You do not need to know the details to embrace the concept: over the course of a lifetime the big variations in returns come from what percentage of your holdings are in stocks. It is simple logic. Because stocks are more volatile than bonds they generate great long-term returns. The capital markets can, and often will, be crazy in the short run. But, they cannot be anything but logical in the long run. The greater return earned by stock over bonds and cash is the market’s way of compensating us for owning them.
The second practice is Diversification. Asset allocation speaks to the broad mix of stocks, bonds and cash. Diversification speaks to the mix within these macro asset classes.
Diversification of stocks says: I can not know which sectors – small or large companies, growth or value, domestic or international – are going to do well, or which will not, in the near term. So I am going to own a broad number of each of these opposing types, in some roughly equal mix. Because they are all stocks I will earn the premium granted to stocks. But, because they tend not to do well all at the same time I will be somewhat insulated from the full volatility of market cycles at any given time.
In other words, “I will never own enough of any one thing to make a killing in it.” And, “I will never own enough of one thing to be killed by it.”
The final practice is Rebalancing. This is returning a portfolio to its target allocation on a regular, disciplined schedule. This practice will virtually always cause the sale of high priced/low vale “hot” market sectors, and the purchase of low priced/high value sectors that are momentarily out of favor. It is a discipline that causes investor to do what they always should do, buy low and sell high.
The adoption of these principles and the implementation of these practices show why those who believe and do these simple six things effortlessly achieve long-term investment results superior to those who do not. And, once more, it’s all about behavior.
