A Two-Timing Tale
“THE NO MAN”
One of the first lessons I learned when I first started investing is the focus of this tale. A wise and successful investor taught me that investing is not like normal work. In normal work, you get paid by the hour or for your efforts. Investing is different. You are not paid by the hour or for your efforts. You get paid to succeed. You succeed by making money, not by taking action. He would say, “When you walk into the office in the morning, if nothing needs to be done that day, your job is to do nothing. If nothing was meant to be done that day and you do something, then you are not doing your job.” This wise and successful Zen-master taught me many lessons, but this was primary in his arsenal. Other tales will focus on when to do something, but this tale has deep undertones that support doing nothing vs. doing something.
Every week I come across an article that shows that individual stock market investors have underperformed vs. the industry benchmark, the S&P 500 stock market index. This is no surprise. Most professional or active managers also underperform the industry benchmark. How can this be? How can professionals, hired asset managers or what I call HAMs, underperform when their only job is to outperform? The answer is obvious. The majority of professional money managers aren’t very good at their profession. Is it a surprise that these alleged pros make exorbitant incomes for mediocre performance? Of course it isn’t. There is a wise saying that, “It is better to be mediocre in an excellent business than excellent in a mediocre business.” But I’ve digressed. This tale is about why individuals underperform and by such a wide margin. I have other tales that focus on the shortcomings of HAMs.
We must get a little technical to understand this tale. There is a mutual fund measurement firm called Morningstar that created a metric that tracks the underperformance of the mutual fund investor and provides insight as to why they underperform. Morningstar calls this metric Investor Return, and it measures how much of a mutual fund’s total return actually goes into investors’ pockets. What makes this metric so valuable is that it measures return based on the number of dollars that flow into the mutual fund as well as out. It tracks the actual investor experience and differs from what the mutual fund publishes. A mutual fund publishes its total return based on an investor buying and holding the mutual fund. However, most mutual fund investors don’t buy and hold. Using a poker analogy, they trade or practice what I call buy and fold instead of buy and hold.
The Investor Return metric measures how an average mutual fund investor performs over time. I suspect that individuals who trade stocks do just as poorly and perhaps worse. The results aren’t pretty. In my opinion, Morningstar’s metric is a breakthrough and sheds light on people’s behavioral tendency to buy high and sell low. It lets us see why so many individual investors and non-expert advisors not only underperform the industry benchmark but also underperform the very mutual funds that they purchase. Please note that there is a case in which this underperformance can appear to happen for mathematical reasons. However it is a construed case with no real world application. I have done extensive modeling on this, and it just isn’t true. While it can happen, it doesn’t happen. The truth is that investors, and this includes their advisors, underperform, and by a wide margin because they exhibit poor behavior. If you read a study that says otherwise, either it is meant either to confuse you or the author is into self-aggrandizement.
What are some of the reasons people underperform? As readers know, I make the assertion that most people, and I mean the vast majority of people, who manage their own money, do a terrible job in terms of performance. So exactly how poorly do these individual investors perform? One study showed that the S&P 500 Index had returned an annualized 12.2% over a 19-year period from 1984–2002, while the average stock mutual fund investor had made just 2.6% over this same time. That’s almost a 10% difference. Why do individual investors perform so poorly? They perform poorly because they “do something instead of nothing.” This underperformance is observable over most any time. It isn’t a statistical fluke. The 10% is high, but is used to illustrate a concept rather than to be precise.
Let’s put this 10% difference in perspective. If you invested $100,000 at 2.6% for 19 years, you would have $162,855. Had you invested it at 12.2% you would have $890,973. This difference of $728,118 is what any statistician would call significant. It’s important for investors to realize that they can’t be subject to stock market risk and the inherent fluctuations for a measly 2.6% if they plan to attain wealth. They can do much better in a risk-free investment. Similar studies that track bond mutual fund returns and actual investor return within these bond mutual funds showed a similar degree of underperformance when you factor the difference between bond volatility and stock volatility into the equation and compare actual investor returns in bond funds to a bond index. This means it’s not just a stock mutual fund phenomena, it applies to bonds as well.
What went wrong? How can it be that the market or the index made 12.2%, but individual investors only made 2.6%? How can you explain this paradox? There is no one answer to this question. A combination of factors leads to this result. However, this tale gets its name because I strongly believe that the primary culprit is what some call market timing or stock market timing. I call it two-timing because you have to be right two times in order to succeed using this strategy. You have to be right on the way in, when you buy, and you have to be right on the way out, when you sell. In this case, a mutual fund market timer is someone who thinks they can successfully trade mutual funds. They think they can correctly pick market tops and bottoms. They think that they can keep their money safely on the sidelines when the market they are trading is going down and invest it when it’s going up. Furthermore, they think they can get out of the market and back to safety at the top of a market and then start the cycle all over again. Morningstar’s metric proves otherwise.
As a good example of the “two-timer,” I present the following. I remember reading that the “C” shares of the Federal Government Retirement System had record inflows in the winter of 1999–2000 and record redemptions in the fall of 2002. The C fund is the equivalent of a mutual fund that mimics the S&P 500, which is in my opinion the best proxy for the general stock market. What happened, how did individual federal government investors fare? At the bottom of what was soon to be the end of the 30-month bear market that ended October 11, 2002, there were record redemptions. Our federal government employees, a highly educated workforce of investors, were selling at the bottom of the stock market. Conversely, at the top of the eight-year bull market that ended in early 2000, these people were at their most enthusiastic and there were record purchases. People were buying at the top of the market. People, even intelligent people, can’t help but sell at bottoms and buy at tops. I have come to believe that it is human nature. The behavior of our federal employees supports my belief in the frailty of the human condition with regard to their money and the markets.
To those who are interested and may want to check, I suspect this same buy high, sell low phenomena transpired near the top of the US stock market in 2007, then near the bottom in early 2009. Similarly, I am sure there are record inflows at this time in 2015, since people are once again euphoric, and there will be record outflows at the bottom of the inevitable next bear market. Markets may not be predictable, but human behavior is.
Getting back to our tale, what other reasons could there be for the disparity in investment returns? The following two reasons may apply to you. You may not be a two-timer, but if you recognize yourself as one of these archetypes, beware, because you are inadvertently timing the market, but for different reasons than the two-timer.
· The 10-minute expert—This individual actually believes they can beat the index over time because they mistakenly believe they have some inherent skill in picking stocks or mutual funds. I don’t know where this belief comes from, but it’s very real. I don’t even know why beating the market is an objective, but it seems to be for many people. I have witnessed this consistently in my dealings with people. I suspect it’s due to the incredible amount of information available to the individual investor on stocks and mutual funds. It’s easy to get lulled into thinking that you can spend a few minutes on a computer and develop stock or mutual fund expertise. You can’t. Expertise takes years of training, but relax. You don’t have to be an expert to meet your wealth-creation objective. These people are not trying to time the market, but they are easily bored with their investments and always want to upgrade their portfolio. They incorrectly upgrade at the wrong time and subsequently they downgrade.
· The past-performance junkie—This type examines the past performance of a fund, extrapolates that performance over time and makes a fatal assumption. They assume that if it did well in the past, it will do well in the future. This is simply not true for them because they don’t have an investment discipline. Although research supports the concept of positive persistence of performance over short periods, called momentum investing, there is also research that supports negative persistence of performance over long periods, called value investing. This is why the two styles of investing, momentum and value, work so well together. This is a very advanced investment concept and most individual investors have not taken the time to understand or develop a disciplined way to take advantage of this time disparity. Future tales, beyond the scope of this book, will show the reader how to use past performance to their advantage, as well as the pitfalls of doing so. To past-performance junkies I say, there is a reason why every piece of mutual fund marketing material has a caveat written in the financial equivalent of neon lights that says, “Past performance is not indicative of future performance.” This should be a big clue to the investor, but they ignore it.
What do the two-timer, the 10-minute expert and the past-performance junkie have in common? They believe that it’s better to do something than to do nothing. Doing nothing is in fact doing something when it comes to investment management. If you don’t transact on any given day, you have consciously decided to do something. You have decided that what you own today is the best that you can own. You have decided to let your financial plan come to fruition by doing nothing that day. As an advisor, I find that this is becoming an increasingly larger problem in the investment management part of my practice as well as for other advisors I admire. Why you may ask? Because so much of today’s media hype focuses on short-term trading, my clients sometimes have difficulty accepting our methods when all they hear is short-term recommendations. They have information overload. You will learn how your advisor, if they are good, can quell this need to trade your portfolio while still maintaining the appearance of activity. A good advisor will always protect you from yourself.
I have read where today’s average stock mutual fund investor holds their mutual funds for less than three years. This holding period is too short, way too short. Current research shows this holding period getting shorter and shorter and reflects our hyper-tech world. If you manage your own money and buy a stock mutual fund, I suggest that your intended holding period be until something significant changes at the mutual fund that you purchased or there has been a significant change in your life and the mutual fund no longer fits your objective. As an aside, my parents have held three different mutual funds for over 40 years, and they still hold them. Why would they change them? They are good, low-cost, low-turnover mutual funds. A significant change does not mean the fund isn’t performing well relative to the S&P 500.
So why is this tale subtitled The “No” Man? I have often kidded with colleagues and clients that I am the “No” man. I say it tongue in cheek because I like to think of myself as doing much more for my clients than just telling them “No.” However, if all I ever or any advisor ever did was say “No,” it would be far better than saying “Yes.” Once you develop the appropriate capital allocation for the specific client and implement your methodology on an ongoing basis, you should become the “no” man. Whenever the client wants to stray from the allocation, tell them “No.” Tell them “No” when they want to sell, invariably at market bottoms when fear runs rampant, and “No” when they want to buy, invariably at market tops when enthusiasm pervades. If the only thing an advisor did was say “No,” and thus protect you from yourself, they would more than earn their fee.
In order to be a confident “No” Man in my opinion the advisor needs to have gone through at least one full cycle of markets that go from bull to bear or vice versa. This need to tame behavior, both yours and the advisors, is why I recommend that when selecting an advisor, you look for someone who has actual time or experience dealing with real markets and real people during real crisis.
Lastly, there is a saying, “Less is more.” This may not be true, but I suspect it is. I often agree with it and believe it applies today in the investment landscape. I suspect investors of old, 30–50 years ago, those that had limited investment choices and could only buy expensive loaded mutual funds or individual stocks that would cost them an arm and a leg to sell, actually performed much better than today’s investor equivalent. We have so many choices and the costs to transact are so low that our market efficiencies and product offerings have exceeded the capacity of most investors to understand. Furthermore, the media has encouraged the “do something” vs. “do nothing” method. I suspect fewer choices, fewer transactions and more expense meant better results for individuals. This sounds insane, I know, but when you look at the Investor Return metric from Morningstar and see the real cost of progress, you might agree.
Investor Return measures the cost of progress, and the cost of progress has two culprits, the individual investor as well as the advisor or alleged expert. They both suffer from irrational behavior.
Why are advisors to blame? For commission-compensated advisors, the answer is easy. The more they buy and sell things, the more they make. Like the car salesman on TV, they say, “Yes” when you want to sell at a bottom and, “Yes” when you want to buy at a top. They are “yes” men and you need a “no” man.
Are fee-based advisors who don’t make money from transactions also to blame? The answer is somewhat complex and is certainly not true for every advisor, but it is for most. Let me give you an example.
Suppose your advisor charges 1% per year to manage your mutual fund or exchange-traded fund portfolio. They select low-cost well-diversified index funds and rebalance appropriately. The funds your advisor selects are, by all standards, best of breed, and the type of funds that our grandfathers and grandmothers would have held indefinitely. Would you as a client of this advisor keep paying them 1% per year for inactivity? The answer in most cases is a resounding no. People want their advisor to “earn” their money and there is an “unwritten” law that says so. Because all they can see are the number of transactions and rate of return, without activity there will soon be a new advisor in the works. So what happens? Your fee-based advisor knows this and feels pressure to do something rather than nothing. They must also take action. They too contribute to the loss of return as measured by the Investor Return metric. They, meaning you, are also falling victim to making less return than the funds they own for you.
Please note that this is not a knock on the fee-based advisor. I am a fee-based Registered Investment Advisor with fiduciary responsibilities. It’s not easy to be either a good individual investor or a good client.
If you want further information, feel free to contact us at www.financialtales.com.