Smarter Investing

Smarter Investing

Steven C. Finkelstein, CFP* and Joel Greenwald, M.D.**, CFP:

Introduction
The chart provided represents the results of the 2007 annual Dalbar QAIB study.† It shows that from 1987 to 2006, the S&P 500 index returned 11.8% per year,‡ while over that same 20-year period the average individual investor in stock mutual funds received a paltry return of 4.3%. How can that be? How can an index that is comprised of the largest 500 U.S. stocks and is accepted as generally representative of the U.S. stock market achieve a return that is nearly 8% per year better than individual investors investing in the same market?

Case In Point
An example of how this can happen is illustrated by the case of investor behavior in a particular stock mutual fund in 1996. During the first quarter of that year, the S&P 500 index returned 5.4%, while this fund gained 18.2%. At the end of March, the fund had only $31,000,000 in assets. Upon seeing this great first quarter performance, investors flocked to the fund. In May and June, they added more than $200,000,000 to this investment — unfortunately, since in the second half of the year, the investment lost 3.8%. For the entire year, the fund returned 32.8%, compared with 28% for the S&P 500. So even though the fund gained more than 32% for the year, its average holder lost 3%.

Cool Heads Prevail
If anything, this phenomenon of “chasing returns” and frequent trading has only become worse since that time. According to Edward S. O’Neal, in the journal Financial Management, mutual fund holding periods declined from 3.75 years in 1992 to 2.4 years in 2000. Rather than following a disciplined plan, investors often jump into last year’s hottest sector of the market or hottest mutual fund.
Now you might wonder, how much difference is there between a 12% annual return and a 4% annual return? At 12%, your investment doubles every six years, and at 4% your investment doubles every 18 years. Through the power of compounding of returns, in the same 18 years that an investment yielding 4% doubles, an investment earning 12% doubles three times or eight times the original investment. It’s hard to get rich doubling your money every 18 years.

†The 2007 study is the most recent annual study available. Prior annual studies by Dalbar confirmed the same sorts of disparities between index and individual performance. The Dalbar method of calculation captures realized and unrealized capital gains, dividend interest, trading costs, sales charges, fees, and expenses.
‡Investors cannot directly invest in an Index.
For further reading on the science of behavioral finance, see Why Smart People Make Big Money Mistakes and How to Correct Them by Gary Belsky and Thomas Gilovich.


Analyzing the Disparity
Part of the difference in returns between the S&P 500 index and the average investor is due to the fees and expenses associated with mutual funds. But these only account for a small part of the annual 8% disparity in returns. The major reason individual investors on average typically underperform in the market is simple: fear and greed. A common Wall Street saying is “Buy low and sell high”. But the average investor does the opposite, buying high and selling low.
During bull markets, when stocks keep going up and it seems easy to make a good return, people flock to equities — and buy high. Then when the inevitable bear market occurs, investors ride the market down until they can no longer stand the pain and they sell — low.
In his October 17, 2008 New York Times opinion piece, “Buy American. I Am”, when talking about the results of investing during the twentieth century, Warren Buffett stated, “You might think it would have been impossible for an investor to lose money during a century marked by such an extraordinary gain. But some investors did. The hapless ones bought stocks only when they felt comfort in doing so and then proceeded to sell when the headlines made them queasy.”
This sort of investor behavior is in evidence today. Just as the stock market tends to go to excessive levels during bull markets, it often declines excessively in bear markets. During bear markets, like the one we are experiencing now, people will often abandon investments when they may be better off holding on, or even making additional investments into sound long-term investments. Buying in today’s stock market climate is what it feels like to buy low.

Checks and Balances
How can you avoid this investment error that costs the average investor so dearly? Our practice is that we follow the “12 Immutable Laws of Investing”, a number of which are designed to overcome the emotional mistakes so common in investing. Do that, and your own decision making will leave you feeling less like you are caught between a bear and a bull on a rock in a hard place.

 

*Steven Finkelstein and **Joel Greenwald are Certified Financial Planners with Sterling Retirement Resources, Inc. in St. Louis Park, Minnesota. www.joelgreenwald.com Registered Representatives offering securities and investment advisory services through Financial Network Investment Corporation: Full Service Broker Dealer, Member SIPC. Financial Network and Sterling Retirement Resources, Inc. are not affiliated. All information is believed to be from reliable sources; however, we make no representation as to its completeness or accuracy. All economic and performance information is historical and not indicative of future results.