Friday, June 28, 2013

Individual Investors and the Pogo Effect ... We Are Our Own Worst Enemies ... So Let's Start Acting Smart and Quit Doing Dumb Things

Over long periods of time, the stock market dependably generates returns of 8% to 10% annually, depending on inflation.

In inflation adjusted terms, the returns have been ~7%.

Yet individual investors don't earn anywhere close to those returns. We do dumb things, and we tend to do them at the absolute worst times.

Individuals trade too often, pay too much in fees and own too many assets other than stocks. Thus, most individuals are lucky to earn 25% of what a diversified portfolio of stocks, such as a low cost passively managed S&P 500 index fund, would deliver to us if we'd just stop trying to outsmart Mr. Market.

The plain mathematical fact is that 50% of people actively trying to outperform the market will be able to do so (expenses, trading costs and investment fees excluded), while the other 50% will necessarily underperform the market. If one active investor outperforms by engaging in active trading, the other person by definition must underperform. That's the math.

Pogo said, "We have met the enemy and he is us." He very well have been talking about individual investors and their tendency to earn below market returns on their long term investments.

7 reasons why retirement savers fail tells the tale of self-inflicted woe for the average individual investor:

"I find it hard to believe how poorly we investors do . . . .

Sometimes it seems impossible to protect people from themselves. Consider these seven key findings:

One: In the 20 years ending Dec. 31, 2012, the Standard & Poor’s 500 Index compounded at 8.2% while the average investor in U.S. equity funds made only 4.3%. In other words, nearly half the return of the market was lost. . . .

For example, imagine a mutual fund with a portfolio that returns 10% in a calendar year. A shareholder in that fund will get that return only if he has money invested on Jan. 1 and leaves it there through Dec. 31.

Any investor who adds money at other times or takes it out at other times will have a different return.

Two: How did investors lose half the return of the market? Where did it go? Three powerful forces took it away. First, investor behavior, mostly emotion-based buying and selling based on emotions, costs two percentage points. That brings the return down to 6.2%.

Second, there's the cost of running funds that are trying to beat the market. The average annual cost of operating a fund, 1.3%, reduces the return further, to 4.9%. Third, portfolio turnover is almost always higher in actively managed mutual funds — sometimes much higher. This can take away another 0.6 percentage points, bringing the return down to the 4.3% ....

Three: Those numbers refer to equity funds. The results were much worse with bond funds. In that same 10 years, the Barclays Aggregate Bond Index returned 6.3% a year; but average investors in bond funds made only 1%.

{NOTE: In a period of rising interest rates, such as we're now entering, bonds are likely to be a terrible investment. In fact, most individual bond investors will probably lose money the next several years. We've previously commented on this bonds-as-a-bad investment issue many times, so we'll not dwell on it herein.}

It's bad enough that equity investors received only 52% of the return of the market. Bond investors, however, got only about 15% of what they could have gotten with a bond index.

Four: There's not much mystery about the source of the problem with investing in bonds. For many years the bond market has been overshadowed with the threat of higher interest rates, a threat that has received plenty of attention in the media....

Five: There is a kernel of encouraging news . . . . Investors in balanced funds tended to hang onto them longer (four years on average) than investors in all-equity funds (three years). But this didn't help a whole lot.

Investors in balanced funds made only 2.3% a year, because of the timing of their purchases and sales, compared with 6.3% for the bond index and 8.2% for the S&P 500.

Six: The shocker in this report, at least to me, is the short holding periods for mutual fund investors. The average investor held equity funds for just 3.3 years. The holding period for bond funds was an even shorter 3.1 years; in balanced funds it was about 4.5 years.

This suggests to me that many investors have unreasonable expectations and are indecisive, impatient and susceptible to Wall Street's constant prodding to do something different.

Investors supposedly embark on long-term strategies in the hope of achieving long-term results. But how can you get the long-term results if you stick around for only a few years?

As a society we don't seem to place a high value on the virtue of patience. We want to lose 20 pounds in 30 days. We want our investments to give us long-term results in a year or less. And if they don't, we are quick to take Wall Street's bait, the hope that surely some expert knows a better way.

Seven: . . . Investment results are more dependent on investor behavior than on fund performance. Mutual fund investors who hold on to their investments are more successful than those who time the market."

The answer, it seems obvious, is for investors to stay in the game. They will do that only if they have confidence in the choices they have made.

I think the most dependable way to achieve the full returns of the market is to invest in a diversified mix of index funds with low expenses. If you couple this with patience and with enough bond funds to keep you within your comfort level, then I think you are likely to be more successful than 99% of all other investors."

Summing Up

To be a successful individual investor, we don't have to be all that smart about finance or the market's inner workings.

We just have to be smart enough not to repeatedly do dumb things.

And that means buying a diversified basket of blue chip stocks and then having the confidence, patience and good sense to stay the course over a long period of time.

Let's prove Pogo wrong.

That's my take.

Thanks. Bob.

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