At the end of each year, the investing community takes stock of the year and compares investment returns. There are several studies that aim to uncover investor returns rather than financial market returns. Each year, these studies show that the average investor struggles to keep pace with the financial markets they invest in.
Below is a chart that shows the average annual return from various asset classes compared to how the “average” investor fared. Obviously, “average”, is pretty piss poor. You might be thinking, “Hey, I’m doing way better than that.” Keep in mind, this looks at a 20-year time period between 1997 and 2016. You have to dig into your memory bank and recount the losses incurred during the Financial Crisis, and the bursting of the Dot.com Bubble.
Source: JPMorgan, Guide to the Markets 4th Quarter 2017
I’m sorry to say it, but I can attest that these results are pretty close to what I saw during my management career on Wall Street. Unfortunately, the average investor has several factors working against them that contribute to these poor results.
Factor #1: The Four Inches Between Their Ears
The “average” investor thinks they know far more than they actually do. What they fail to realize is that successful investing requires them to do the opposite of what human nature tells them to do. When an investment goes up, human nature encourages them to get in because they can make money (i.e. – greed). On the other hand, when an investment tanks, their natural impulse is to jump ship and save what’s left of their investment (i.e. – fear).
Simply put, their brains are wired to “Buy High and Sell Low”, not “Buy Low and Sell High”. In a very simple sense, the latter is what every investor is trying to do. While it’s easy to talk about doing the opposite of human nature, actually doing it is an entirely different story. On top of that, it’s even harder to do it consistently year in and year out. It’s a feat that not many can accomplish.
Factor #2: The Four Inches Between Their Advisor’s Ears
Many Financial Advisors will point to the same chart above and argue this is why investors need professional investment advice. The problem with that argument is that the study that produces the “average” investor return, also encompasses accounts managed by professional advisors.
Here, common sense plagues the “average” investor in two ways. First, it’s completely rational to seek professional help when it’s needed. They hire an attorney to handle their legal matters and a CPA to file their taxes, so why not a Financial Advisor to help with their investments? The problem here is that the person providing that advice is influenced by the same human emotions that make the average investor “average”.
For some reason, they think that a professional advisor is immune to the effects of human emotion. I would argue that, because Advisors are immersed in financial markets every day, they are more likely to be influenced by short-term swings in the market, and therefore, more likely to make a mistake.
Believe it or not, it’s not uncommon to see excessive trading and large losses in the personal accounts of financial advisors. I’ve actually seen advisors that had to be reprimanded for this behavior. It’s actually such a problem that some investment firms set trading restrictions on employee accounts.
To be fair, it’s hard to lump every investment advisor into one group because the difference between good and bad can be extreme. This is no different with investors.
Factor #3: Active Management Underperformance
Mutual Funds have been a staple of investment portfolios for decades. In their heyday, they were the preferred method for getting diversified exposure to financial markets. As reporting and data aggregation has improved, we’ve gained better insight into how professional money managers perform. Unfortunately, the numbers don’t look good for active managers or the investors that use them. In fact, more than 90% of mutual funds that are measured against the S&P 500 fail to keep up with the index.
Source: S&P Dow Jones Indices LLC, Morningstar
Even though most professional money managers can’t beat the market, countless amateur investors feel compelled to try to pick their investments themselves. Over the short run, some will be successful doing it themselves. However, as time goes on, it becomes increasingly less likely that a DIY investor will be able to best the returns of professional portfolio managers, let alone the market.
Factor #4: Investment Fees
Generally speaking, you can’t make an investment without incurring some costs. However, providers of exchange traded funds are getting pretty close. Whether you’re buying an index fund, an individual stock or bond, or some complex investment product, there’s no way of getting around paying some fees. The problem is, that in many investor portfolios, there are layers upon layers of fees that quietly eat away at their portfolio. Account fees, transaction fees, mutual fund fees, advisory fees, the list can go on and on.
The trick is to keep your fees low. Fees can have a huge impact on your investments over the long run. Keep in mind, what you save in fees isn’t just money you didn’t have to pay; it’s money that stays invested and compounds over time. A $100 fee savings today could end up being worth $1,000’s down the road. The ETF industry has attracted huge amounts of capital because they offer some of the lowest fees.
Unfortunately, by reducing fees you are removing the incentive for an advisor to provide you advice. Advisors are paid out of the fees and commissions that your account generates for their firm.
Indexing using ETF’s has largely become popular since the 2008 Financial Crisis. What most investors don’t realize is that while passive investing outperforms active during good years, it actually underperforms during bad years. In fact, the number of mutual fund managers that outperform the market spikes when the market is down big. There a several reasons why this happens, but we’ll save that for another post.
What Can The “Average” Investor Do?
There are two things investors can do to help improve their investment results going forward.
First, remove subjective decision making wherever possible. It’s subjective decisions that lead to poor decisions by investors, advisors, and professional money managers a like. Instead strive for objectivity with your investments. Decisions that are based on rock-solid data with little to no interpretation needed.
Second, watch your fees like a hawk. If you want to see a financial advisor squirm in their chair, ask them how much you’ve paid in fees. Sure, it’s an uncomfortable thing to ask. It’s even more uncomfortable for your advisor because they will likely have a hard time accounting for all the fees that you could be charged. If you can’t have an open discussion about what you’re being charged, it’s time to look for another option.
At Prepared Capital, we use a rules-based investment process that has be tested over several market cycles. There’s little-to-no subjectivity that leads to the poor results we discussed above. Our website offers a 5-minute Portfolio Review that allows you to run a side-by-side comparison of your portfolio versus one of ours. We’ll show you the difference in fees, performance, and asset allocation.