Early in my flying career, I discovered that success or failure, life or death, heavily depended on resisting the overwhelming urge to do something incredibly stupid. When things began to go wrong, the temptation to take shortcuts or abandon carefully thought out procedures mounted. Stress led to mistakes, while it is the avoidance of mistakes that leads to a long and happy life. In other words, I quickly learned that my own behavior could be a primary threat to my longevity.
Preventing yourself from doing the wrong thing just to relieve the stress of the moment is a key to survival. More than one pilot has feathered the wrong prop, blown the wrong fire bottle or shut down the wrong engine by jumping into a problem before he had carefully thought it through. Mistakes like that can quickly ruin your whole day.
The Air Force has recognized that under stress, pilots perform hasty, ill thought out actions leading directly to disaster. For this reason, millions of dollars and thousands of hours of training time are aimed at helping pilots establish disciplined, rational and logical thought processes for when the pucker factor rises. The primary emergency procedure which every crew member in the Strategic Air Command has to recite during oral exams is, “Stop-think-collect your wits!” In other words, get a grip!
Pilots command incredibly complex machines in threatening environments. Yet few accidents are caused by aircraft or system failure alone. Inappropriate pilot action, or pilot error, remains a leading cause of aviation accidents.
Investors, like pilots, operate in a complex environment. The environment occasionally produces moments of stress but basically the environment is friendly. Like in aviation, in the field of finance the primary cause of investor failure is their own behavior! Many of them are their own worst enemy. To put it bluntly, they haven’t yet learned to resist the overwhelming urge to do stupid things with their money! Investors, like pilots, can benefit from disciplined, rational, and logical thought processes when the pucker factor rises.
What’s Going On Here?
An examination of investor returns provides some startling and depressing insight. Investors don’t even come close to market returns. How can this be? If markets are efficient, then most investors should have very close to market returns. It should be very difficult for investors to screw up in a game so strongly rigged in their favor.
I have often stated that the value of the average stock broker’s advice is worth far less than zero. The large brokerage houses are understandably concerned that this perception should not spread. Brokers, of course, would like investors to believe that their advice adds value. A recent study by Dalbar Financial Services, Inc., supports both positions! The report, 1993 Quantitative Analysis of Investor Behavior, divided mutual fund investors into either “sales-force advised” or “non-advised.” The study then examined the investment results for both equity and bond funds for a ten year period (January 1984 to September 1993).
In equities, the sales-force advised clients led the no-load do-it-yourselfers by a wide margin. Advised clients had a total return of 90.21 percent while the do-it-yourselfers got only 70.23 percent. Dalbar observes, “The advantage is directly traceable to longer retention periods and reduced reaction to changes in market conditions.” We could impute that sage advice from the brokerage forces led to sharply improved returns.
This stunning victory for the brokerage force pales when we notice that the market as measured by the S & P 500 returned 293 percent! Dalbar continues: “Trading in mutual funds reduces investment returns. The ‘buy and hold’ strategy outperforms the average investor by more than three to one after ten years.” Investor returns in both equity and bond categories were directly related to hold time. Longer holds equaled higher returns.
Friends, this is not a question of slightly sub-optimal performance. This is a total disaster! How are Americans going to educate their children, retire in comfort, or meet any other reasonable financial goals when the average total performance of their equity investments falls short of thirty percent of the market’s?
Incidentally, during the study period inflation rose 43.12 percent so the average American equity investor had very little to show for his ten years in the market. And investors racked up this dismal result during one of the ten best years the market has ever given us. For all the reasons we have previously explored, Americans can simply not afford this dreadful performance.
Investors in bond funds did no better compared to the bond market indexes. Their interest rate predictions and market timing served them just as poorly.
In order to appreciate the full magnitude of this disaster, it is important to understand that the study did not consider the larger question of whether investors ought to be in bonds, stocks, or cash. It only considered the results investors got relative to the broad general market in which they committed funds.
Presumably many investors in cash or bonds ought to have been in equities, and as a result far underperformed their actual needs. Available evidence suggests that many Americans are reluctant to assume even reasonable risks necessary to meet reasonable financial goals. Systematically investing in the wrong markets and then seriously underperforming those markets is a sure-fire recipe for catastrophe.
Investors Do the Strangest Things
Another section of the study traces month by month net cash flows by equity mutual funds against the returns of the S & P 500. The pattern leaps off the page at you; market goes up, investors pour money in, market goes down, investors take money out. Classic buy high and sell low! The process is repeated over and over and over with mind numbing regularity. Investors simply could not restrain themselves from churning their own accounts. Folks, if you haven’t noticed yet, this is not the way to make money!
During the study, investors displayed an amazing ability to market time in reverse, as they floundered and flip-flopped without any apparent strategy. However, the worse an investor’s returns were as a result of his inept market timing attempts, the more likely the investor was to blame the funds rather than himself!
Dalbar concludes: “The more an investor buys and sells funds, the lower the potential return.” Overall, “Investors should focus less on buying the right fund or funds, and more on modifying their own behavior.”
After twenty-three years of watching investors do the strangest things, I can add a hearty, “Amen.”
Mutual fund performance itself cannot be blamed for this awful result. The funds may be expected to turn in a performance slightly less than the indexes because of their fees, trading expenses and requirement to keep some cash liquid for normal redemptions. But the average fund performs where we would expect, about two percent below the broad market indexes.
There is a huge discrepancy between the fund’s return and the return of the average investor in that fund. At a meeting I attended just a few years ago, Peter Lynch, retired manager of Fidelity’s Magellan Fund, disclosed that a shocking percentage of his fund’s investors actually lost money! Now, no fund in the entire history of the universe has been more successful than Magellan. However, Magellan has been volatile, and the swings have alternately attracted investors and then frightened them off – just at the wrong times! The only thing Magellan (or most equity fund) investors needed to do to achieve truly great returns was just to stay invested. But, a surprising number of them just couldn’t make themselves do the right thing.
Investor behavior is so perverse and investor returns so dismal that a whole branch of economics is devoted to trying to find out what makes investors tick. One recent study of investors found that no matter what they tell you about thinking long term, most investors’ perceptions and expectations are heavily influenced by their experience of the last eleven and * months. If the markets have been doing poorly for the previous year, investors begin to believe that they will continue to do poorly forever. They begin to sell. If they have been doing well, investors become euphoric and begin to believe “that this time it is different.” The higher the market price goes, the more they want to buy. You needn’t be a rocket scientist to see how this leads to self-defeating behavior.
What Have Investors Learned?
We must wonder if investors have learned anything from their dismal experiences. The answer appears to be a resounding NO.
The average investor has not the foggiest notion that she even has a problem so she is several long steps away from starting to think about it. Survey after survey finds widespread misunderstandings of even the most basic financial concepts. Even investors who rate themselves as highly sophisticated have trouble distinguishing between stocks, bonds, CDs, and mutual funds when asked very simple questions.
My personal experience confirms the survey results. I can’t remember ever encountering a potential client that had any idea what his actual investment experience had been or how his experience had compared to any broad market index. Not one of my professional or business owner clients could guess within ten percent of what his portfolio rate of return was. I have never had a client who has been able to describe his investment strategy. Most appear to have invested aimlessly in scatter-shot fashion, hoping that something will work for them.
Another root cause of poor investor performance is self-delusion about risk tolerance. Hundreds of psychologists have tried to design questionnaires to root out investors’ real risk tolerance. Unfortunately, we don’t often get the correct information until the market declines. Then we find out what the investor really meant.
For instance, when investment advisors ask a potential investor about risk tolerance, the answer is often misleading. If asked if he could endure a ten, fifteen, or twenty percent decline in asset value he will often answer yes. Even if the advisor tries to convey that the question is not a test of courage or “manliness,” investors may not want to appear timid. What the investor may mean, but would never say, is “But, I’ll be out of here!” At the first downturn, the investor is gone. This, of course, locks in a loss and prevents a normal market recovery from making the investor whole, putting him back on the profit side.
Investors have to determine in advance what their real risk tolerance is. Perhaps they should ask themselves how much decline they could endure and still stay with the program. Once an investor knows what her real risk tolerance is, she can adopt a strategy with a high probability of never exceeding the allowable loss.
Unrealistic expectations about either potential short-term declines or long-term positive gains will often lead the investor astray. An investor who has accepted the range of reasonable possibilities for both is far less likely to shoot himself in the foot. So, advisors must not oversell and investors must not con themselves. The more you know about how markets are liable to act, the better prepared you are to keep a long term horizon firmly in mind.
The Tuna Fish Factor
Nick Murray is one of the brightest and most entertaining guys in my industry. You probably haven’t heard of him because he writes and speaks to financial advisors about how to motivate our clients to do the right thing for themselves. Helping clients to overcome their fears and avoid self defeating behavior is one of the biggest problems we have. Nick shared the great idea of comparing investor behavior to grocery shopper behavior in his monthly column in Investment Advisor Magazine.
Let’s pretend that you, your family, and your cat eat a fair amount of tuna fish. As you know, tuna fish comes in cans and has a long shelf life. We are used to buying it in large cans for $1.50. Now one day we go to the market and see that it is on sale for $1.00 a can. What do we do? Do we see ourselves as impoverished because we have some cans back home on the shelf? Do we run home, grab all our unused tuna fish and then run back to the store to sell it back? Of course not! We buy lots of tuna fish to take advantage of the low price. We know that we will need tuna fish for a long time and that the sale offers us a great opportunity to stock up for future needs. We have made the mental jump that LOW PRICE = GOOD.
Stocks have a long shelf life too and we should buy them in order to use them a long time in the future. But the average investor seems to operate on the assumption that LOW PRICE = BAD! Instead of seeing temporary low price as an opportunity to buy something he will need in the future, he wants to dump what he has. Nick and I have a little trouble trying to figure this kind of logic out.
Zen and the Market Experience
America is a can-do country. Our heroes are action-oriented and full of the right stuff. Most successful people got that way by using their skills to make something happen. Business responds well to can-do positive active management. If business turns down, there are lots of things a smart businessman can do: make more phone calls, hire more sales people, buy advertising, change the product, have a sale, fire the sales manager, buy the competition, increase commissions, or move to a better market. Success in business is an active management kind of thing.
Investing is a different kind of cat. It is a very passive activity, somewhat Zen-like. Markets don’t respond to our can-do attitude. We can’t just whip them into shape. They have their own flow. We must attach ourselves to the world’s markets and allow them to carry us to our goals.
More often than not, if you have a good strategy in place, the best single thing an investor can do during a disappointing season is nothing! Of course, this type of thinking can make a successful, can-do, action oriented, gung-ho investor just a little crazy. During times of stress, negative performance, or non-performance, the investor wants to do something! All kinds of self-defeating behavior comes to mind: fire the advisor, liquidate the account, move to another brokerage, sell the funds, circle the wagons, and pull in the horns. The fund that looked so good during last year’s bull market now looks like a turkey. An advisor that recommends standing pat obviously just doesn’t get it, must be some kind of a wimp, can’t have the right stuff, is quite obviously a dull tool, and is trying to justify her poor performance. Any idiot can see that things are falling apart all over and so we need action! NOW!
Investor impatience is compounded by a relative pain, relative time problem. Market downturns hurt a lot more than good times feel good. It is many times more painful to see your portfolio lose one percent than it is pleasant to see it gain one percent. And it feels longer. Two years of back-to-back declines, under-performance, or even non-performance can feel like a lifetime. As we have seen, even a superior portfolio will go through occasional extended periods of disappointment.
To make things even worse, no matter how bad things may get for our investor, somewhere somebody is making money. Those people will certainly tell all within earshot. Most investors have a very selective memory. We all seek approval and would like to be considered astute, sophisticated, and successful. During social gatherings or casual conversations it’s not unusual to stress the positive and repress the negative. So the investment winners in our portfolios tend to get talked about more than the losers. Or, investors with disappointing recent performance will say nothing. After all, who wants to broadcast failure? So, the “winners” brag and the “losers” keep mum. Soon, it may seem to our poor investor like everybody with an IQ over room temperature is making money except him.
So, the temptation to second guess himself grows and grows. If only he or his advisor had been more astute, he would be making money too. Perhaps it’s time to try something else like all those other smart investors are doing.
Once that cycle starts, it can deteriorate into a tail-chasing fiasco. At least dogs that chase their tails remain on level ground. Investors can dig themselves into a hole as they ratchet themselves ever downward chasing yesterday’s heroes.
The hard-driving, results-now type investor is familiar to every investment advisor and counselor. But there are other investors who also become their own worst enemies. For instance, the overly analytic investor never gets started because she never has enough information to make a decision. No matter how much data she has, it’s never enough. No matter how many options she considers, there might be a better one. In the end, she never does anything. Of course, from her perspective she has never made a mistake!
Unfortunately, unlike an accounting or engineering problem, investment data changes every minute. We never have all the data and so risk can never be eliminated. Research can suggest superior strategies but never perfect ones. Investors who wait for perfect solutions may never get started. This behavior is fondly known within the profession as “Paralysis by Analysis.” In Chapter Ten, we saw the cost of excessive delay. Time is the investor’s great friend and shouldn’t be frittered away. Investors need to get it together and get going, otherwise they are never going to get there.
By their very nature, investment markets carry risk. By now, you are familiar with the traditional definitions of risk. However, we must consider if perhaps investors may pose the biggest risks to themselves.
More Advice From Mom
When I was very young, I got my first two-wheeler. It took a while to get up the courage to actually get on and ride. However, shortly after my first successful ride I learned to ride “no hands.” Shortly after that I decided to try standing on the bicycle seat while coasting downhill. My mother observed my efforts and commented that I was being just a little too cute for my own good. This comment was very shortly followed by a spectacular crash.
Left to their own devices, many investors get a little too cute for their own good.
The world’s markets offer an easy way for long-term investors to profit from the expansion of the world’s economy. It’s called “buy and hold.” An investor has to work pretty hard to screw up this simple formula. However, as we have seen, most do. As Pogo, the great comic strip character of my youth, used to say, “We have met the enemy, and he is us!”
“Buy and hold” is a very dull strategy. It lacks pizzazz and doesn’t inspire much admiration at cocktail parties. It has only one little advantage – it works very profitably and very consistently.
Your Investments Are Your Future!
There is a lot riding on the decisions you make. As you make those decisions, don’t trip yourself. Investors with no knowledge, no plan, no discipline, no benchmarks, and no clue have no chance. They would be only slightly worse off to take their money to the dog track, or even play lotto!
It’s hard work to build and implement a superior portfolio. But, that is not nearly as difficult as maintaining that portfolio through thick and thin so that you reach your financial goals. The temptation to do something truly stupid can seem almost overwhelming. Train yourself to resist it!
It may be helpful to run fire drills with yourself. Think about what your reaction would be if you were to wake up tomorrow and find that your portfolio had gone down twenty-five percent. Would you panic and dump everything? Or, would you say to yourself, “Gee, Frank told me there would be years like this. Risk happens. Well, it’s going to be OK.” Would you still have the same attitude a year or two later? The more you think through the possibilities in advance, the more likely you are to make good decisions.
The investment process is like most other things in life. In the long run the difference between winners and losers boils down to knowledge, superior strategy, and discipline. Books like this, other research, or good advisors can provide knowledge and define superior strategies, but only you can supply the discipline.
Many investors lack the knowledge, time, and inclination to manage their own funds. If so, they would do well to hire a professional. However, the best investment manager in the world will do them no good if they lack the discipline to stay aboard.
The equity train will always reach the investors’ financial goals. Only the disciplined investor will still be on board.
It would be easy to snicker at the apparently clueless behavior of most investors. That is certainly not my point. Investors are not just naturally dumb people. Most are very successful in many other aspects of their lives and careers. Our schools, the media, and the financial services industry have all done an unforgivably bad job of educating Americans to make reasonable financial decisions. Much of what we know now about the behavior of markets is very recently acquired knowledge. But, the word is not getting out. Next chapter we will look at the role that industry, media, and advertising disinformation play in the investment process.