How to Think About Investing #1 — Setting the Stage

In order to explain how we think about investing here at Woodmont, as well as to help our clients better understand their own investments, we are beginning a series of short posts about how best to think about investing.

This is of great importance, as the data is quite conclusive that the average investor has abysmally under-performed vs. the broader market indices.

As Figure 1 highlights, stocks have generated a respectable 8.2% annualized since 1996, while the average investor has generated only 2.1%.

Figure 1. 20-Year Annualized Returns by Asset Class (1996–2015)

 

Source: Blackrock, Dalbar

Consider the wealth implications for an example case study of a Mr. and Mrs. Smith. The Smiths, age 30, earn 300,000 annually, and plan to save 10% of their take-home pay each year for retirement. At a targeted retirement age of 65, if the Smiths are able to capture the average returns of 8.2% during that 35 year period, they will retire with approximately $5.8 million.

Let’s suppose that our fictional couple is more like the average investor highlighted above, and rather than 8.2%, they only earn 2.1% during that period of time. Their ending retirement balance is $1,796,000, a staggering difference of $3.9 million.

So why is the individual investor missing out on almost 6.1% annually? There are two major reasons why this disparity of returns happens: The behavioral tendencies of the average investor and excessive fees.

Reason 1 — Behavior

It is common sense to say, but the goal is to buy low and sell high. Yet, overwhelmingly the data reflects that investors do just the opposite. Investors, both individual and institutional, tend to follow the herd, by buying in and staying too long in the best performing asset classes and not buying what is cheap.

The driver for this in its simplest form is our own brain chemistry. When stocks are going up and we are making money, our brains reward us with a lot of ‘positive’ dopamine. The reverse is true when stocks are falling. As such, rather than thinking with our ‘risk management’ hats on, we tend to think in terms of gain and loss. When we experience losses, we are less likely to behave rationally, and tend to hold our losers far too long, hoping for a rebound.

A second way this manifests is by buying and selling too much. The average investor trades too frequently and misses out on performance through the mis-timing. As Figure 2 highlights, investors typically sell under-performing fund managers just before their performance begins to recover.

Figure 2. Fund managers get fired right before their performance improves.

 

Source: “The Selection and Termination of Investment Firms by Plan Sponsors.” by A. Goyal and S. Wahal, Journal of Finance, August 2008

The collective of these behavioral challenges hurts investor’s ability to stay in the market long enough to generate good returns, or avoid significant drawdowns by rebalancing when assets classes have become too expensive.

Reason 2 — Excessive Fees

Investors, generally, pay far too much in investment expenses. Between excessive commissions, unfavorable classes of mutual funds, and other layered fees, some investors may be paying between 2–3 percentage points annually in investment fees. Over time without a significant offset from substantially higher performance, this has a negative impact on the value of a portfolio. Figure 3 looks at the potential impact of various fee levels on a $1 million portfolio growing at 5% over a 30-year time horizon.

Figure 3. Fees Matter

 

As can be seen, the impact of higher fees is a significant headwind over time.

Improving the 2.1% Average

Given the reasons we noted above, the question is how do we help claw-back some of the 6.1% of missing returns for the average investor.

Let’s tackle the easiest problem first, investment expenses. The solution is quite simple — buy Wholesale versus Retail. At Woodmont that means for the majority of clients’ portfolios, we purchase bonds directly versus adding another layer of manager fees and expenses. For equities, we prefer low-cost index funds , ETF’s, or buying stocks directly versus using a mutual fund. This fee sensitivity is driving the shift from active to passive management with nearly 20% of stock market investments now made via index funds and passive exchange traded funds (ETFs).

Yet ETFs and Index Funds are Not a Panacea

While lowering fees can absolutely help improve returns, it is not a magical cure-all. The behavioral problem we highlighted still remains. Steve Romick at mutual fund manager, First Pacific Advisors, highlighted this in a recent letter.

We don’t suggest that passive management is bad and that active management is good. They can both be effective tools, if used wisely. It’s hard to argue with passive investing’s lower fees, tax efficiency and market-matching performance. Passive investing, however, is only as good as an investor’s ability to buy and hold those funds in periods of volatility.
Excessive shareholder turnover could cause a typical investor to under-perform the benchmark even in a passive fund. To the detriment of long-term returns, most investors have shown a greater propensity to sell into a bear market and then not return until the market has rebounded to levels above where they initially sold . In our view, these investors exchange the higher fees of actively-managed funds for an illusory peace of mind associated with passive investing.

Even with a portfolio of low-cost index funds, it is still possible for the investor to significantly under-perform if they are chasing the hottest sector or strategy. Passive investing vehicles such as index funds and ETFs are great ‘tools in the toolbox.’

When addressing the behavioral challenges that lead to average investor under-performance, it is more important to thoroughly articulate the specific goals of an investor and the level of volatility the investor is able to withstand. This information is vital guidance in constructing an appropriately diversified portfolio. Having a well-defined plan in advance allows the portfolio to compound through time when accompanied by regular re-balancing.

Real dollars are at stake with average investors under-performing by 6.1% each year. Investors have responded thoughtfully by attacking the low hanging fruit of fees as a way to help bridge the gap. We would agree, fund managers who generate index returns should not receive greater than index compensation. Yet we would encourage investors that while lower fees certainly help bridge the gap, the investment behavior of each person may be the ‘biggest rock’ of them all. Educating yourself about your own behavioral tendencies, establishing financial goals, assessing your level of risk sensitivity, and partnering with a thoughtful fiduciary advisor are all important steps in this process.


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