Today continues a series, to appear roughly once per month, on the main ways that the financial system rips off the average worker and investor. This is based upon my nearly decade-long tenure in the financial services industry.
Investor Returns vs. Investment Returns
The sad truth of the financial world is that almost no one should be an investor in the market. This would include most everybody who is in the financial services industry as well as anyone not so employed. This seems like a rash statement. I mean everyone knows someone who has had a great experience in the market. The neighbor who rode a great stock tip to stellar returns, the advisor who touts their amazing record when going over your plan or your second cousins third best friend who has traded their way to riches all anecdotally tell us that even average people can be successful investors.
The facts, however, tell a different story. The key concept to grasp is the difference between Investment Returns and Investor Returns.
Investment Returns is the number you hear on the news. The Dow rose 200 points today; The S & P 500 was up 13% this year or the NASDAQ was down 4% this quarter. This is the headline number that gets talked about at the office or in policy discussions.
Investor Returns on the other hand are what you and I or our friends and neighbors make in the market. This experience can vary markedly from the headline returns you see on television or read about in the paper. When you invest during a year; how you invest, whether systematically or all at once, and whether you take any withdrawals all have a significant impact on your personal returns. It is understanding this difference that is the key to grasping how poor have been the returns of the average investor.
Every year since 1976 a company named Dalbar, Inc. releases a report on investor behavior. Dalbar has long been in the business of evaluating the business practices as well as the quality and performance of companies in the financial services sector.
The most recent report sheds light on the difference between Investment Returns and Investor Returns. This report details that over the previous 30 years the S & P 500 has returned an average of 9.65%. Yet the average investor managed returns of just 6.81%. As the summary indicates this can lead to substantially lower gains over time, less than half in fact. Believe it or not, this represents a bit of an improvement over previous reports.
Clearly the average investor has managed to create a situation in which they buy high and sell low. The question is why?
Dalbar gives a list of behavioral explanations for this divergence:
- Loss Aversion – The fear of loss leads to a withdrawal of capital at the worst possible time. Also known as “panic selling.”
- Narrow Framing – Making decisions about one part of the portfolio without considering the effects on the total.
- Anchoring – The process of remaining focused on what happened previously and not adapting to a changing market.
- Mental Accounting – Separating performance of investments mentally to justify success and failure.
- Lack of Diversification – Believing a portfolio is diversified when in fact it is a highly correlated pool of assets.
- Herding– Following what everyone else is doing. Leads to “buy high/sell low.”
- Regret – Not performing a necessary action due to the regret of a previous failure.
- Media Response – The media has a bias to optimism to sell products from advertisers and attract view/readership.
- Optimism – Overly optimistic assumptions tend to lead to rather dramatic reversions when met with reality.
There is a large body of literature explaining the psychology of investor behavior and a whole discipline of behavioral investing, the best analysis I have seen is this fine work by Charles D Ellis. There is no need to go into depth here concerning the intricacies of these studies. All of them can be summed up into two large behavioral categories which explain horrid investor behavior.
The Twin Terrors: Fear & Greed
Fear and greed sum up why investors fare so poorly in their attempt to meet or beat the market. Let’s look at the fear first. The Dalbar study make clear that in the last 30 years, investor underperformance was most acute in October 2008. That was the second month of the financial crisis that plagued Wall Street and Main Street…. One can anticipate when investors may be most vulnerable to their negative behavior by looking back at history and seeing the “Maximum Impact” events that led to their decisions in the past…. The years 1987, 1997, 2000 and 2008 each contained 2 of the top 10 most acute underperforming months, indicating that acute events tend to travel in pairs. The years cited in the study, of course, coincide with severe downturns in the equity markets. It is not coincidence that investors underperform during these periods of high stress. They simply bail out during severe market downturns but do so at almost the low point in the investment cycle. They bailed out at nearly the low point of the market cycle in December 2002, just before the market recovered from the tech bubble bursting and began a multi-year move upward. Investors flowed out of funds in December 2008 just before the cycle low in February 2009. The average investor was almost perfect in their ability to lock in losses.
On the greed side the timing is just as awful. Investment flows hit a cycle peak in December 2000 just before the tech bubble burst; flows hit another peak in February 2007, just in time to have the bottom fall out during the Great Recession. This cycle is repeated endlessly and has been for decades. Investors pile into the markets after a lengthy run up because they get greedy and figure that they cannot lose because the market will continue in that same direction for a much longer period.
Now there are those that would make the case that this reality is why investors need financial advisors and actively managed accounts to assist them. The facts speak otherwise. The disparity between investment returns and investor returns occurs whether the investor is utilizing an advisor or not. The disparity exists whether the investor is investing in an actively managed fund or a passively managed fund. If a client is going to panic no amount of persuasion on the part of the advisor will change that client’s mind (assuming the advisor has not panicked as well). The advisor will not risk losing the client to their competition so they will make whatever trade the client wishes (they are of course legally obliged to in any event, or they would have to resign the account).
As for active vs. passive management there is no substantive difference either. An actively managed fund may stay in the market through a downturn, but the client will not stay in the fund. A passively managed fund may take the stock selection task from the client but not the decision as to whether to stay invested. This study shows that the results for DIY investors is no higher than the overall average.
Not Suited by Training or Temperament
The reason for this wretched investment behavior is simply that average investors are not suited by either training or temperament to participate in the equity markets. There is nothing in the background or psychological makeup of an average investor that would give anyone confidence that they could be successful in this endeavor.
Most investors do not pursue a course of study that would lead them to significant knowledge of securities analysis or investing strategy. Even business majors have only a cursory exposure to these concepts. One can have a thorough understanding of corporate finance and accounting, but these are of little help in understanding how markets move. This situation only gets worse as investors progress in their careers. Their knowledge gets more and more specialized to suit the needs of their employer and their industry and they become ever more removed from the concepts of securities analysis and investing strategy.
Psychologically the story is even scarier. Maybe one in a million has a psychological makeup suited to investing. Think of how few Warren Buffets there are in the world to grasp a sense of this. To invest with conviction; to buy at market cycle lows; to sell near market cycle highs takes a level of intestinal fortitude that few possess. To watch while everyone says the market is going one way while you go another; to suffer drawdowns prior to gains and have those you care about tell you that you are wrong is psychologically crushing to most people. It’s crushing to most professional money managers. (This explains why even money managers engage in herd-like behavior-better to lose money as part of a group than all by yourself). The average investor, who is not that one in a million Warren Buffet is almost guaranteed to underperform.
No one in their professional lives would behave like this. Think of any business you may be engaged in. You may be a lawyer, a doctor, or work for a manufacturer or a service provider. You may be in sales or administration or in a technical role. In any event, if the company you worked for faced a rough month or quarter or even a year you would in no way consider liquidating the company and getting out of the industry altogether. This is because you know your field of endeavor. Because of this you are confident that you and your co-workers possess the expertise to correct whatever problems you have and get back on track. Additionally, it is likely that no one else in your industry is liquidating and bailing out either.
Contrast that with investing. You don’t have the expertise to determine if you should stay invested or not, everyone else, even professionals are liquidating, and you are not playing with a paycheck (serious enough that) but with your family’s retirement assets. Is it any wonder that investors behave the way they do and so consistently underperform?
This is not a moral critique. Nobody should be ashamed that they cannot perform as an investor. They never signed up for this in the first place. Average people find their way into a career, and they learn it and try as best they can to earn what they can and save what they can to provide for their families. The fact that most people are poor investors proves only that most people are human.
The sad fact of the matter is that none of this is endogenous to the market. It is simply not natural. A concrete set of policy choices, benefitting a concrete set of interests was put into place that forced average workers into the equity markets. These interventions and deformations of the free market have indeed enriched some but have caused the mass of ordinary citizens to become that which they are not: investors. In the process trillions of dollars have been squandered and untold amounts of stress heaped upon them in the process. It is these policy choices and their implications that we turn to in Part 3 next month.
Praise Be to God