Mistake #2 – Strategy is to “Beat the Market”
July 10th, 2009
One of the biggest reasons investors underperform the market is that they try to beat it. Since the early 1970s there have been two competing theories on how to get better investment returns. Active Management is the oldest and still most widely held. The goal of active management is to “beat the market”. The last time I checked about 93% ($6.5 trillion) of all mutual fund dollars were actively managed.
Passive Management is the relatively new theory which is gaining acceptance among a growing number of academics and institutional money managers. The goal of passive management is to “capture market returns” by simply investing in a statistical sampling of the whole market and eliminate all the costs of trying to beat the market. About 7% ($500 billion) of all mutual fund dollars were passively managed.
Active management begins with the assumption that stock and bond prices do not always reflect their “true” or “intrinsic” value. Active managers spend billions of dollars on research to find the “mispriced” securities. Using fundamental analysis, technical analysis and market timing, professional money managers actively trade (buy & sell) securities in search of higher investment returns.
Passive management begins with the assumption that free markets, while not perfect, are a very effective mechanism for setting prices for anything, including publicly traded companies and bonds. In other words, the the capital markets are just as efficient as the free markets for automobiles and toothpaste. Proponents of passive management like to say that the only people who don’t believe free markets work are the Cubans, North Koreans and believers in active money management.
The “market” is all investors together, functioning like a super computer processing all the information about a company and calculating the best estimate of the intrinsic value of a company at any particular moment. This estimate is called the “fair market price”. Investors who try to beat the market, believe they know something the supercomputer does not. I like to compare passive management with the game of golf. Instead of trying to beat the golf course by scoring birdies and eagles, investors who adopt passive management are satisfied with par. Instead of trying to beat the golf course, they are satisfied with beating 99% of all other golfers (active managers) who spend billions of dollars and make a lot of mistakes trying to overcome almost insurmountable odds.
Can information be bad for investors? Prof. Paul B. Andreassen from Harvard University, compared the investment performance of four groups of investors. Two groups managed a volatile growth stock like Google. The other two groups managed a stable value stock like Sears. In each pair of groups, one group was fed a steady stream of news reports about their stock, while the other group received no information. In both pairs, the group that received no news performed better than the group that was given a steady stream of information. In fact, the investors who received no news and traded the volatile growth stock performed twice as well as the investors who received regular updates on the company’s performance!
How can this be? How does easy access to financial news and the ability to track portfolio values harm investors? Researchers in behavioral finance observe that when investors receive new information there is a natural tendency to “do something” in reaction to that information. It turns out the human brain is programmed to act on new information.
In most cases, acting on new information is good. But when it comes to implementing a long term investment strategy, it’s usually disastrous. Information stimulates emotions which in turn increase the urge to act. So a steady stream of information about losses, moves investors to sell. Later, a steady stream of news about market gains, induces investors to buy. Without realizing it, most investors have abandoned their strategy, if they had one in the first place (See previously posted Mistake #1). Driven by natural urges to act on information, investors unintentionally implement a strategy of selling low and buying high.
Watching daily movements in your investment portfolio is like watching paint dry. Imagine a paint job with a one-hour drying time and checking it every minute by touch to see if it’s dry. Sixty fingerprints can ruin a great paint job.
Assume your portfolio has at least a ten (10) year time horizon. Checking the value every day is like touching the paint 3600 times an hour to see if it is dry. One of the worst things we can do after creating and implementing our investment strategy is to touch the paint. Treat all the daily headlines like static on the radio. Ignore them. Because information can be harmful to investors, we recommend the discipline of an annual investment review.
Rebuilding Trust in Financial Markets and Advisors
June 7th, 2009
While on a New York media tour for our new company, Peoples Financial Advisor, I heard one question more frequently than any other: “What are you doing to rebuild people’s trust?” At the time, financial reporters were losing their jobs because trust was in very short supply.
Trust is the foundation of all business, including the advertising dollars that support media. Without human trust, a modern economy cannot exist and capital markets cannot function. Money itself is an invention of human trust. Whether it’s in the form of clay tablets, coins or plastic credit cards, money is nothing more than a “promise to pay” and belief in the promise. So I don’t think the problem is public trust. The economy is still functioning and as far as I can tell everyone is still using money. We are by nature an optimistic people. We want to trust our government, financial institutions and advisors.
But we’ve just learned that we’re never more vulnerable than when we trust. Misplaced trust created the economic bubble. The loss of almost twenty trillion dollars or 40% of personal wealth is a measure of our financial vulnerability when we, the public, misplace our trust. I personally think the new found skepticism is healthy. I believe the personal losses in our real estate and financial portfolios were the “price” of a valuable lesson for all of us.
So what am I doing to rebuild trust? From 16 years of counselling and building non-profit organizations I learned that the way to win trust from others is to focus on being trustworthy. I want Wall Street to spend fifty billion dollars a year on becoming trustworthy instead of advertising to win trust. I want the media to acknowledge it has the same conflict as the cigarette industry. I want the financial media to post warnings that it cannot survive if it doesn’t arouse emotions and sell copy and “this advice may be hazardous to your financial health.” I want regulatory reform to require an authentic fiduciary standard of care for anyone offering financial or investment advice to the public.
As for individual investors, what were our expectations before the collapse? Were they reasonable? Did I expect for-profit financial institutions and advisors who sell products to put my interests ahead of profits and compensation? Did I believe that I or my advisor could beat the market by looking into the future to pick winners and avoid losses? What lesson will we learn from our losses? Will we blame advisors, the media, politicians, financial institutions or capital markets? Will we learn not to trust anyone or anything? Will we return to the days of putting our money in the mattress and not asking anyone for advice or help? If so, we may be setting ourselves up for more disappointment.
It’s true, we are never more vulnerable than when we trust, especially when it comes to money and love. But it’s also true that if we never trust we will never experience financial freedom or rewarding relationships. Perhaps some of us just need to rebuild our trust in ourselves. Everyone has the ability to learn. Everyone has the ability to make better financial decisions. Trust me on this.
Someone once said broken trust is like a glass vase. You can glue it back together, but it will never be the same. I agree to a point. If people learn from their losses, their trust will be reinforced with wisdom.
