Are You Your Portfolio’s Biggest Enemy?
| November 16, 2011 | Posted by Roshawn Watson under Uncategorized |
By: Roshawn Watson
You work hard. You research companies. You even gather expert opinion and public sentiment regarding your investment choices, yet your returns are not commiserate with your effort. In fact, your long-term returns are dismal compared to market averages. This is the world of many investors today. Despite the increasingly lauded financial literacy programs, investors are struggling with two primary problems: their own nature and a well-polished Wall Street machine that loves ignorant investors.
Is Your Gut Leading Your Investments Astray?
The investor’s chief problem—and even his worst enemy—is likely to be himself. (Benjamin Graham)
A large data set analyzing household investing found just how damaging gut-driven trades can be to our wealth. Over 66,000 households with accounts at large discount brokerage firms between 1991 and 1996 were evaluated. The average household annual return during this period was 16.4%, and portfolios typically turned over around 75% of their stocks annually. The market (NYSE/AMEX/Nasdaq) returned 17.9% during that same period. However, the households that traded most frequently had an average annual turnover of 250% and only earned a 11.4% annual return whereas those who traded infrequently earned 18.5%. The obvious implication of such findings is that most individual investors were better off investing and taking a nap rather than playing the trading game.
Another study evaluated 10,000 brokerage accounts over a seven year period found intriguing differences in returns between buyers of stock and sellers. The investigators wanted to see who did better, the sellers of a stock or the buyers. On average, the shares investors sold did better than those they bought, by a very substantial margin: 3.3 percentage points per year, in addition to the significant costs of executing the trades comparing two stock. Thus, the data, opinions, and hunches leading the purchasers to think that it was a good time to buy XYZ stock were clearly wrong!
Trading typically has deleterious impact on wealth-accumulation.
The key question is if our ideas are so golden, then why doesn’t the data back them up? Often overconfidence plays a strong role in high trading levels and the corresponding lower returns by individual investors. Many times our forecasts are little better than blind guesses. While this fact alone should give us pause, often the dismal quality of our predictions has very little impact on our future judgments. Frequently, our “strong yearnings” and “informed decisions” are our the biggest threats to our portfolios.
Ignorant Investors Beware
All that shines is not gold.
Nevertheless, there is another dangerous offender that can seriously hurt investors. Investors must know that the polish and veneer of sophisticated analyses, wonderful academic pedigrees, complicated products, and A-list clientele associated with Wall Street wealth advisers often obscure the reality: few stock pickers possess the skill required to beat the market consistently, year after year. A 2009 Morningstar, a Chicago-based research firm, study focusing on individual investors reported that just 37 percent of actively managed U.S. stock mutual funds beat their respective Morningstar indexes after accounting for risk, size and fund style. Your odds of picking an actively managed fund that beats the market for more than a couple years are pretty small. For most individual investors, it is generally better to “easily avoid underperformance” rather than pursue the “futile chase of market-beating performance.”
Nonetheless, a recent good performance history and an endorsement from an advisor can be remarkably seductive to investors hungry for returns. This isn’t to say that many advisers aren’t hard working and highly experienced professionals who genuinely believe they have what it takes to pick the next winners. In fact, many believe they are providing value to their clients. However, what they are typically offering are merely educated guesses at best. The problem is that these guesses tend to be no better than chance and are repeatedly beaten by the market benchmarks.
Along this same vein, the correlation data is also pretty convincing with respect to the role of chance in our returns. A correlation is a way to see the relationship between two variables. The stronger the correlation, the stronger the relationship. Thus, if a year-to-year return showed a strong correlation, then that would suggest that these two returns are strongly related to each other. Perhaps if both returns were good, you could even assume that whoever designed the portfolios (or picked the stock) yielding those returns is the most important variable. In other words, he or she possesses some special knowledge or resources yielding a competitive edge in the market. Moreover, if he or she was able to replicate these results over a longer time frame, such as 20 to 30 years, you would have a much more robust data set. Such data would be considered more valid compared with an incidental finding. This is important because a group of researchers recently looked at 28 year-to-year correlations for 25 anonymous wealth advisers and found that there was ZERO correlation between their returns. In other words, there wasn’t any discernible pattern, despite the superstars advisers being the common denominator. The most reasonable interpretation is that the differences were due to chance not the skill or educated guesses of the talented investors. By the way, if you think this consistency criterion is too stringent, consider this same metric has been used successfully to quantify the existence of skill among “golfers, orthodontists or speedy toll collectors on the turnpike.” Thus, if skill was involved in producing the sporadic market-beating returns, the correlation data should support it.
Show Me Your Financial Statement
In no way am I writing this to put down advisers but rather to educate investors. There are some investment advisers who are very informative, such as Robert at DIY Investor, and endeavor to serve their clients extremely well. However, there are many others who are mostly smoke and mirrors. They have clever sales pitches that don’t consistently translate into market-beating results for their clients, after you adjust for risk, fees, etc. Perhaps, this is why when one of the decamillionaires profiled by Tom Stanley in his famed Millionaire Next Door series was approached by a wealth adviser, he told the adviser that he would only obtain his business after his review of the adviser’s financial statements. The decamillionaire wanted to make sure that the adviser was able to generate significant returns off of his own investments not off of his ability to sell financial products. The adviser went on to scout another client. The implication of the story is that our concern should not focus on what someone says they can do for us but whether they can get results, particularly results in their own lives. That kind of authenticity is rare. Most people who sell investment products make their living from selling not investing! Being a good salesman has nothing to do with being a great investor.
That’s why Wall Street doesn’t necessarily like savvy investors. Even when Wall Street is involved with well-intentioned financial literacy programs, such as the Mutual Fund Educational Alliance, which has been around since 1971, it ultimately served as little more than an marketing ploy for the fund industry to push their products to willful participants under the guise of educating them.
Let me say this clearly: many financial firms have an uncanny ability to extract considerable sums of wealth from an unsuspecting public. They’re the smart money. Think very carefully before betting against the house!
Closing Thoughts
In summation, between battling overconfidence and an ever-craftier Wall Street, investors are struggling to find their footing in a very tumultuous economic climate. We should not be deceived by either ourselves or others, regardless of professional credentials. If for one second, we let ourselves believe that we got the system beat (or that we can’t invest on our own), we often have already loss. Don’t be a victim of overconfidence in yourself or Wall Street!
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I am a very cautious investor. In fact I don't even have a lot of investments yet and that is because I don't like to rush into things. There have been very few opportunities where I feel really comfortable. I guess this hurts me profit wise but I prefer the minimization of risk.
If you have a financial adviser, ask if he gets compensated for the securities he recommends. That creates conflict of interest.
For this reason, I prefer flat-fee advisers.
Some risk adversionis a healthy thing. I would much rather be reasonably caution than overly cavelier. I think deciding on your investment strategy is a very critical step. Rushing into the decision is not recommended anyway.
I prefer flat-fee advisers too. It's a weird way to think about it, but sometimes the most expensive advice is freely given.
It's difficult to be an investor these days with the terrible return. I was more active when I started out and did not do very well. Now, most of my portfolio is in Index fund/ETF. I keep adding to my position to take advantage of dollar cost averaging and it's much less stressful.
I still buy and sell a few individual stocks, but they are a small portion of my total portfolio.
I like your strategy a lot. Mine is very similar. There's such power in simplicity; it's tragic that more people don't avail themselves following benchmarks, at least for a significant part of their portfolios.
These are very challenging times for investors. Sometimes, I wonder what I would be like if I was investing 30 years ago. Oh well. Thanks for the comment Joe. Cheers!
Very well said! I like large positions in cash or cash equivalents, and speculate in individual stocks with only a portion of my total portfolio. The test of patience is when the returns columns is bleeding red. 😉
Andrew, I can defintely appreicate your position wholeheartedly. Speculation is fun, I don't believe that most people would be so willing to play with their retirements if they truly understood all of the risks.
Returns columns bleeding red is definitely the ultimate test of patience. Cheers! 🙂
This is exactly why I do not invest much in individual stocks. I have made some dumb moves out of fear, and so I know it is best for me to stick with index funds. Exception: My husband's stock purchase plan- just can't beat the deal, and also some individual dividend stocks I have bought.
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I do better by getting the emotions out of the investing and dealing with index funds, except for a small amount of money on the side that can be used for more.
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I definitely concur. Emotions can wreak havoc on great financial plans.
It is called wait for bargains and dollar cost average on lows
Chris
All too often, that's exactly when people are selling: "cutting losses"
I have been pretty good at selecting mutual funds that outperform their averages for many years. I haven't been so good at picking individual stocks. Luckily, most of my savings are in great mutual funds.
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I'm so happy that you have had success. It's unfortunate that so many people don't understand the fundamentals of investing. I know it may be an inherently dry subject, at least according to my wife :), but it is also critical to any wealth plan. I suspect you have a very strong plan! Cheers!!!
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I am FOR SURE my worst enemy. I'm an idiot a lot of the times and need to protect myself from myself.
I constantly swing for the fences!
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I have to protect myself from myself too. It's funny how easy it is to "overthink" or "underthink" something so critical. There's way too much at stake to be struggling so much with basic investing decisions. Cheers!
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