Personal Finance

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.

From 1988 thru December 2007, investors underperformed the stock and bond markets by -7% and -6% respectively.  It is an empirical fact that individual investors sabotage their own portfolios because they have no strategy.  If you think you are an exception, you should have what professionals call an Investment Policy Statement that describes your strategy by answering questions like the the following:

What is the target return for your investment portfolio?   4-6%?   7-9%?   10-12%?   

How much risk are you willing to take in order to get that return?   Are you willing to lose 40% of your portfolio one out of every five years in order to have a 65% chance of averaging 12% over 20 years?   How much risk is acceptable as defined by the “volatility” or “variablity” in your annual returns?

What is the time horizon for your portfolio?   When do estimated withdrawals from your portfolio exceed the contributions and earnings?  Ten years from now?  Twenty years?  Fifty years?

How many asset classes do you use?   Three?  Five?  Seven?  What is your target allocation for each asset class?  What are the band limits?  When do you rebalance?

Have you chosen an active or passive management philosophy for security selection?    

If you have chosen active management for the equity (stocks) asset class, what strategy have you selected?   Do you buy growing companies or beaten down value companies?  Do you use a buy and hold, momentum or market timing strategy?

Achieving investment goals requires a plan and a strategy.  One of the most frequent mistakes investors make is they have no written plan or strategy to address some of these most important questions.

There is a difference between investor and investment performance.  In 2008 the US stock market, as measured by the S&P 500, lost 37.7%.   But investors did even worse by losing 41.6%.    The US bond market, as measured by the Lehman Aggregate Bond Index gained 5.2%, but bond investors actually lost 11.7%.   In other words, the stock market as an investment outperformed investors by 3.9% and the bond market beat investors by 16.09%.  

This is not just a one year phenomenon.   Every year the Dalbar company measures how investors performed compared to the capital markets themselves.   For the 20-year period from 1988-2007, the US stock market, as measured by the S&P 500 returned 11.81%, but equity investors only earned 4.48%.  For the same period, the US bond market, as measured by the Lehman Aggregate Bond Index, gained 7.56%, but fixed income investors earned only 1.55%.   In other words, over the past 20 years the stock market outperfomed investors  by 7.33% and the bond market beat investors by 6.01%.   If we’re not shocked, we should be.

What are investors doing wrong?  How do they unintentionally sabotage themselves?

These are ten broad categories of mistakes that we have seen investors make:

1. They have no strategy
2. Their strategy is to beat the market  (Market Failure Theory)
3. They don’t hold themselves accountable (No Benchmarks)
4. They listen to the media more than the math (The Loser’s Game)
5. They don’t count the impact of costs (SEC Cost Calculator)
6. They let emotions overrule numbers (Behavioral Economics)
7. They don’t understand or set a portfolio time horizon
8. They don’t define long term (Speculators vs Investors)
9. They don’t understand all the risks
10. They measure risk tolerance instead of risk capacity

Most investors believe they are the exception, but it’s pretty easy to prove they are not.   People’s Financial Advisor offers a Financial Checkup that will estimate the cost in your personal portfolio from just one common mistake.  In future postings we will explore each of these mistakes in greater detail.