Having spent years overseeing hundreds of financial advisors who manage thousands of accounts for investors you gain a perspective for what works and what does not. You see those who have successfully grown (and preserved) their wealth, and others that squandered it on market bets that didn’t pan out. Here we will cover three themes that investors should avoid.
Complex Is Not Better, but It Does Sell Better
I’ve heard thousands of presentations from investment managers who claim they have a process that’s better. “Our process is superior because (insert jargon here).” Over time, these strategies, and their presentations, have gradually increased in complexity. It’s sort of a one-upmanship among financial professionals. This behavior is largely rewarded because complexity sells. Unfortunately, in the world of investing, simple usually wins. In the end, you end up with complex investment strategies that sell well but don’t necessarily perform.
Edsger Dijkstra was a software programmer but his quote about simplicity vs complexity is spot on for the world of investing.
“Simplicity is a great virtue but it requires hard work to achieve it and education to appreciate it. And to make matters worse: complexity sells better.” Edsger W. Dijkstra
Take for example the 2007 wager where Warren Buffett bet a hedge fund manager one million dollars that over the next 10 years an S&P 500 index fund would outperform five hedge funds. This is a perfect case of simple vs. complex investment strategies squaring off against one another. On the surface, you’d think that the hedge funds should have the advantage. Their research and trading teams are staffed with some of the brightest minds Wall Street has to offer. How can a simple index fund have a chance? This is a perfect example of how simple works. At the end of 2017, Buffett won the bet with ease. The index fund grew at an annualized rate of 7.1%, where the group of hedge funds grew at just 2.2%.
More Activity Does Not Equal Better Results
In fact, more often, it’s the opposite. Forget about the outcome of any one investment for a moment. The more investments you make, the more transaction costs you’re going to incur. Additionally, any short-term gains you realize will be taxed as ordinary income which further eats into your gains. During my management career in finance, the most common trait among our wealthy clients was that they didn’t “trade” the market. Keep in mind, more than 90% of professional money managers (those running equity mutual funds) can’t outperform the market. Read that last sentence again and let it soak in. Yet thousands of investors step into financial markets everyday thinking they can do better.
Admittedly, you can’t blame them. The business media churns out countless articles per day on what’s happening in financial markets. Investors can’t help but feel empowered to invest based on what they see in the media. Take Jim Cramer for example. He is an ex-Hedge Fund Manager turned TV personality who provides advice on which stocks investors should buy and which they should sell. He has garnered a huge following and is a good source for information about individual companies and their stocks. However, a 2016 academic study by the Wharton School at the University of Pennsylvania found that even Jim Cramer doesn’t beat the market (article). The vast majority of investors would be better off buying a low-cost index fund and leaving it alone.
What Happened Yesterday, Doesn’t Necessarily Happen Tomorrow
Human nature has a funny way of making poor investors. It is in our nature to think that whatever has happened over recent history will continue into the future. In 2006, everyone thought, “home prices can’t go down”. Prices had been rising rapidly for years and people assumed that this trend would continue. We know how that ended.
In the world of Behavioral Finance, this is what is called “Recency Bias”. It presents itself in some very interesting ways. Take, for example, a craps area inside a Las Vegas casino. It’s common to see a disproportionate amount of people crowded around a small number of tables. Those tables are likely the ones where someone is on a “hot streak”. More and more people pile around the table to place their bets hoping they can get a piece of the action. It is as if this person is throwing a pair of dice that are somehow different than the ones at every other table. I got news for you, they’re the exact same dice and your odds of winning are the same on every roll regardless of the table or the crowd around it. And, because a Las Vegas casino is a for-profit business, the odds are never in your favor. This isn’t just isolated to home prices and Las Vegas casinos.
It happens in the world of investing every day. For example, if you have a 401k through your employer you probably have a menu of funds to choose from. Typically you’re able to see a slew of information about each fund to help guide your investing decision. Unfortunately, most people simply look at the historical performance of the available funds and pick the ones that have done the best recently. Again, thinking that whatever happened in the past is likely to continue into the future. Unfortunately, this rarely happens.
When you’re evaluating your investment options, it’s important to not only look at past performance, but also the investment landscape that existed during. A fund that invests primarily in stocks might have a good 5-year track record, but it’s been a great 5-year period for the stock market as a whole. How will that fund fare when the environment is less favorable for stocks?
No single investment works well all the time. What is happening in the overall economy has an enormous impact on how investments perform. Naturally, if the economy is expanding like it has for the last nine years, stocks typically do very well. However, stocks tend to perform terribly when the economy enters a recession.
To help protect investors from recessions, we developed an algorithm that predicts recessions. Our Business Cycle Indicator predicted each of the last seven recessions.