When Dr. Krause ran his MOOC in
2013 and 2014, he presented similar results to those presented in this March
3, 2014 article which appeared in the New York Times. It highlights an
interesting mistake that most investors make. It is also important in highlighting for the students in the AIM program that process and consistency are important elements in effective long-term portfolio management.
The author is Carl Richards is a financial planner in Park
City, Utah, and is the director of investor education at the BAM Alliance. His
book, “The Behavior Gap,” was published in 2012. The following is his article as it appeared in the NY Times blog.
We’re still making the same old mistake of buying investments when prices are high and selling them once their prices have fallen.
I had hoped things had changed, I
really did. But Morningstar’s latest Investor Returns data says
otherwise. More than 10 years after I first started thinking about this data,
the behavior gap still exists. The behavior gap is what I refer to as the
difference between what the average investment returned and what the average
investor earned.
What’s the difference? Pretend for
a minute that we have a mutual fund with a 10-year-average return of 10 percent
per year. That’s the investment return. If you put your money in the fund, kept
it there for the entire 10 years, and didn’t add or take out any money, then
your investor return would also be 10 percent. So in this very hypothetical
example, the investment return and the investor return were the same.
The problem is that few people
invest this way. Who would buy a long-term investment and actually hold on to
it for the long term? That would be silly!
Most people buy and sell. We hunt
for the next rock star mutual fund manager and follow our brother-in-law’s tips
at the family barbecue. In fact, as Nate Silver points out in his book “The
Signal and the Noise,” the hold times for stocks have declined
every decade until the 2000s. Today, we hold our stock investments for about
six months. We’re clearly not what anyone would think of as long-term
investors.
It’s easy to understand why we
behave this way. We’re hard-wired to get more of those things that give us
pleasure or security, and to run away from things that cause us pain. That
trait has kept us alive over thousands of years, but it makes us terrible
investors. When we follow our natural instincts, we end up buying things after
they’ve gone up. Then, when they go down, which they always do at some point,
we sell.
The weird thing is that we do all
this believing we’re protecting our families’ futures. But this
well-intentioned behavior has a cost. As Morningstar’s data shows, the average
equity mutual fund in the United States had a 10-year average return at the end
of 2013 of 8.18 percent. The average investor only earned 6.52 percent. That’s
a difference of 1.66 percentage points. It may seem like a small number, but it
makes a big difference when you think of it in terms of dollars.
Imagine 10 years ago that you put
$100,000 in an average American equity mutual fund. If you just sat there,
you’d have $219,517 in your account at the end of 10 years. But because we’re
human, you more likely only earned the 6.52 percent return of $188,066. That
equals losing more than $30,000, a 17 percent difference.
The numbers are even more
depressing in other investment types. Balanced mutual funds are designed to
help us manage our behavior by including both stocks and bonds. They provide a
cushion in down markets in exchange for not hitting it out of the park on the
way up. It seems like that would help us behave. Well, the average balanced
fund returned 6.93 percent, but the average investor only managed 4.81 percent.
It’s critical to understand that
none of this is the investment’s fault. The average investment did its thing,
but our behavior determines what we actually get. What makes this so
frustrating is that we’re talking about an average American equity fund, not
the best one, just the average. In other words, all we had to do to improve our
return by over 1.5 percentage points was pick a mediocre (by definition,
average) equity fund and then just sit there.
Instead, we ran around reading the
latest research, watching CNBC and looking for the best fund because that’s the
American way. Why settle for average when you’ve got a shot at being among the
small minority that can pick out a stock or a mutual fund that will beat the
market?
The past is the past, and there’s
nothing we can do about it now. But here’s the key: The next 10 years start
today. If the past is any indication of the future, we need to do something
different if we want a different result. The hard part of investing isn’t
picking the best investment. Instead, it’s sticking with the one we’ve picked.
Only then will we have a shot at closing the behavior gap over the next 10
years.
The best part about this is that
once you design a portfolio, the only thing you have to do is nothing, aside
from some occasional rebalancing when some investments rise and others fall. It
reminds me of my favorite Warren Buffett quote: “Benign neglect, bordering on
sloth, remains the hallmark of our investment process.” As he’s demonstrated
more than once, investing is one place where we are rewarded for being lazy.
