One of the first lessons I learned when I first started investing is the focus of this tale. A wise and successful investor taught me that investing is not like normal work. You don’t get paid by the hour, by the piece or for your efforts. You get paid to succeed. You succeed by making money not by taking action. So he would say “When you walk into the office in the morning, if nothing needs to be done that day, your job is to do nothing. If you do something that day then you are not doing your job.” This wise and successful zen master taught me many lessons but this was primary in his arsenal. Other tales will focus on when to do something but this tale has deep undertones that support doing nothing vs. doing something.
Every few years I come across an academic study that shows that individual stock market investors have under-performed vs. the industry benchmark called the S&P 500 stock market index. This is no surprise. Most professional or active managers also under-perform the industry benchmark, though they do much better than individuals. How can this be? How can professionals, hired asset managers or what I call HAMs under-perform when their only job is to out-perform? The answer is obvious; the majority of professional money managers aren’t very good at their profession. Is it a surprise that these alleged pros get paid exorbitant incomes for mediocre performance? Of course it isn’t. There is a wise saying that “it is better to be mediocre in an excellent business than excellent in a mediocre business.” But I’ve digressed. This tale is about why individuals under-perform and by such a wide margin. I have other tales that will focus on the short-comings of HAMs.
We must get a little technical in order to understand this tale. There is a mutual fund measurement firm called Morningstar that created a metric that tracks the underperformance of the mutual fund investor and provides insight as to why they underperform. Morningstar calls this metric Investor Return and it measures how much of a mutual fund’s total return actually goes into investors’ pockets. What makes this metric so valuable is that it measures return based on the number of dollars that flow into the mutual fund as well as out. It gives you a glimpse of the actual investor experience and how it differs from what the mutual fund publishes. A mutual fund publishes its total return based on an investor buying and holding. But today most mutual fund investors don’t buy and hold. They trade or practice what I call “buy and fold” instead of “buy and hold.” This metric measures how an average mutual fund investor performs over time. I suspect that individuals that trade stocks do just as poorly and perhaps worse. The results aren’t pretty. In my opinion Morningstar’s metric is a breakthrough and sheds light on people’s behavioral tendency to buy high and sell low. It lets us see why so many individual investors not only under perform the industry benchmark but also under-perform the very mutual funds that they purchase.
What are some of the reasons people under-perform? In An Expert Tale I make the assertion that people that manage their own money do a terrible job in terms of performance. So exactly how poorly do these individual investors perform? One study showed that the S&P 500 Index had returned an annualized 12.2 percent over a 19- year period from 1984-2002 while the average stock mutual fund investor had made just 2.6% over this same time frame. That’s almost a 10% difference. Why do investors do so poorly? They do poorly because they do something instead of nothing.
Let’s put what this 10% difference means in perspective. If you invested $100,000 at 2.6% for 19 years you will have $162,855. Had you invested it at 12.2% you will have $890,973. This difference of $728,118 is what any statistician would call significant. It’s important for investors to realize that they can’t be subject to stock market risk and the inherent fluctuations for a measly 2.6% if they plan to attain wealth. They can do much better in a risk-free investment. Similar studies that track bond mutual fund returns and actual investor return within these bond mutual funds showed a similar degree of underperformance when compared to a bond index. So it’s not just a stock mutual fund phenomena; it applies to bonds as well.
What went wrong? How can it be that the market or the index made 12.2% during this time frame but individual investors only made 2.6%? How can you explain this paradox? There is no one answer to this question since it’s a combination of factors that leads to this result. However, this tale gets its name because I strongly believe that the primary culprit is what some call market timingor stock market timing. I call it two timing because you have to be right two times in order to succeed using this strategy. You have to be right on the way in when you buy and you have to be right on the way out when you sell. In this case a mutual fund market timer is someone that thinks they can successfully trade mutual funds. They think they can correctly pick market tops and bottoms. They think that they can keep their money safely on the sidelines when the market they are trading is going down and invest it when it’s going up. Furthermore, they think they can get out of the market and back to safety at the top of a market and then start the cycle all over again. Morningstar’s metric proves otherwise.
As a good example of the Two Timer I present the following;
I remember reading that the “C” shares of the Federal Government Retirement System had record inflows in the winter of 1999-2000 and record redemptions in the fall of 2002. The C fund is the equivalent of a mutual fund that mimics the S& P 500, which is in my opinion the best proxy for the general stock market. What happened, how did individual investors fare? At the bottom of what was soon to be the end of the 30-month bear market that ended October 11, 2002 there were record redemptions. Individual investors were selling at the bottom of the stock market. Conversely, at the top of the 8-year bull market that ended in early 2000, people were at their most enthusiastic and there were record purchases. People were buying at the top of the market. People, even intelligent people, can’t help but sell at bottoms and buy at tops. I have come to believe that it is human nature. I can’t explain why since I am not a behavioral expert but I have written a number of Behavioral Tales that supports my belief in the frailty of the human condition with regards to their money and markets.
What other reasons could there be for the disparity in investment returns? The following two reasons may apply to you. You may not be a Two Timer but if you recognize yourself as one of these archetypes, beware, because you are inadvertently timing the market but for different reasons than the Two Timer.
1) The 10 Minute Expert- This individual actually believes they can beat the index over time because they mistakenly believe they have some inherent stock picking or mutual fund picking skill. I don’t know where this belief comes from but it’s very real. I don’t even know why beating the market is an objective but it seems to be for many people. I have witnessed this consistently throughout my dealings with people. I suspect it’s due to the incredible amount of information available to the individual investor on stocks and mutual funds. It’s easy to get lulled into thinking that you can spend a few minutes on a computer and develop stock or mutual fund expertise. See An Expert Tale for a better understanding of what it takes to be an expert. These people are not trying to time the market but they are easily bored with their investments and always want to upgrade their portfolio. They incorrectly upgrade at the wrong time and subsequently they downgrade.
2) The Past Performance Junkie – This type of investor looks up the past performance of a fund and extrapolates that performance over time and makes the fatal assumption that if it did well in the past it will do well in the future. This is simply not true for every time frame. While research supports the concept of positive persistency of performance over certain time frames there is also research that shows negative persistency of performance over other time frames. The individual investor has not taken the time to understand how to take advantage of this time frame disparity. In A Tale of Hindsight, which I have yet to release, I will show the reader how to use past performance to their advantage as well as the pitfalls. So to Past Performance Junkies I say, there is a reason why every piece of mutual fund marketing material has a caveat written in the financial equivalent of neon lights that says, “Past performance is not indicative of future performance.” This should be a pretty big clue to the investor but it’s ignored. See A Rebalancing Tale for a better understanding of the effects of past performance and one of the ways that you can take advantage of it for your portfolio.
What do the Two-Timer, the 10-minute Expert and the Past Performance Junkie all have in common? They believe that it’s better to do something than to do nothing. Doing nothing is in fact doing something when it comes to investment management. If you don’t transact on any given day you have consciously decided to do something. You have decided that what you own today is the best that you can own. You have decided to let your financial plan come to fruition by doing nothing that day. As an advisor I find that this is becoming an increasingly larger problem in the investment management part of my practice as well as other advisors that I admire. Why you may ask? Because so much of today’s media hype is directed towards short term trading my clients sometimes have difficulty accepting our methods when all they hear is short-term recommendations. They have information overload. I will release An Action Tale shortly to see how successful advisors deal with a client’s need to transact.
I have read where today’s average stock mutual fund investor holds their mutual funds for less than 3 years. This is too short of a holding period, way too short. Current research shows this holding period getting shorter and shorter over the last 20 years. If you manage your own money and buy a stock mutual fund, I suggest that your intended holding period be until something significant changes at the mutual fund that you purchased or there has been a significant change in your life such that the mutual fund no longer fits your objective. As an aside, my parents have held three different mutual funds for over 40 years and they still hold them. A significant change isn’t that the fund isn’t performing well relative to whatever you may want to compare it to. I know that the funds we use, or said a different way, the HAMS we select for ourselves and our clients have proven the test of time and are ones we think we can hold almost indefinitely. Using our approach, we may sell a few shares or buy a few more based on our model, but the core fund holdings stay intact. See A Tale of Diversification as well as A Rebalancing Tale to better understand or develop an investment method that you can use for the long term.
So why is this tale subtitled the “No” Man? I have often kidded with colleagues and clients that I am the “No” man. I say it tongue in cheek because I like to think of myself as doing much more for my clients than just telling them “no.” But if the only thing I did or any advisor ever did is develop the appropriate capital allocation for the specific client and then whenever that client wanted to stray from the allocation tell them “no” when they want to sell, invariable at market bottoms when fear runs rampant and “no” when they want to buy, invariable at market tops when enthusiasm pervades, I or any advisor would more than earn their fee. In order to do this in my opinion the advisor needs to have gone thru at least one full cycle of markets that go from bull to bear or vice versa. So in the soon to be released A Fairy Tale you will understand why I recommend that when selecting an advisor that you look for someone that has actual time or experience dealing with real markets and real people during real markets.
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