Wednesday, June 10, 2015

Investing Really Shouldn't Be Risky Business

By Keenan Mann

In the movie Risky Business, circa 1984, Tom Cruise, who plays a character named Joel Goodsen, has an adult-language philosophical moment with a college recruiter from the University of Illinois who has made a backhanded criticism of Joel's academic efforts after reading his high school transcript.  If it had not already been, I suspect that Joel's classic response, "You know Bill, sometimes you just gotta say, 'what the f#@k''', became a mantra for many who watched the film. After all, who could argue against the idea that one should live for the moment, given that life is short and stuff happens, right?

Well, New York Times financial writer, Jeff Sommers did - kind of anyway.  In a recent article, he shared this stunning conclusion based on research by Boston research firm, Dalbar: 

"The numbers show that most people who are lucky enough to have money to invest end up underperforming the markets by staggering margins. A big reason for that is living in the moment — acting in response to ephemeral events....Most of us would be much better off we focused relentlessly on the far horizon, sticking with a simple and cheap plan for getting there....When investors think short-term and try to time the market, they haven’t done very well. They have been leaving a lot of money on the table."

Mr. Sommer's also concluded the following based on data from Dalbar:

"For the two decades through December, Dalbar found, the actual annualized return for the average stock mutual fund investor was only 5.19 percent, 4.66 percentage points lower than the 9.85 percent return for the Standard & Poor’s 500-stock index. Bond investors did even worse, trailing the benchmark Barclays Aggregate Bond index by 4.71 percentage points.

In isolation, these figures, which aren’t adjusted for inflation, may seem small. But they aren’t when they recur year after year. In fact, because of the effects of compounding — in which a positive return in one year adds to your stash and can grow further in subsequent years — those annualized numbers translate into life-changing disparities.

Consider a $10,000 investment in the S.&P. 500 index. Using the Dalbar rates, my calculations show that with dividends, that $10,000 would grow to $65,464 over 20 years, compared with only $27,510 over the same period for the return of the average stock mutual fund investors.

That gap grows over time. At those rates after 40 years, with compounding, the nest egg invested in the plain vanilla stock index would grow to about $428,550, compared with only $75,680 for the average returns of stock mutual fund investors, a $352,870 difference. Disparities of this order have been showing up year after year in the Dalbar numbers. And with so many Americans forced to rely on their own investing acumen because of the decline of traditional pension plans and lax government rules about financial advice, these awful returns really matter."

So why do the index funds do so much better that the active mutual fund managers?  Well for one the fees are significantly lower with the passive index funds (recall rule number 4 of Warren Buffet's Five Bedrock Principles from Bob's recent post was, 'When in doubt, choose the investment with the lowest fee."

In addition to fees eating into the returns though, the aforementioned ephemeral events, which typically receive wide coverage by the news outlets, also play a big part. Those events can lead to big swings in asset (stock/bond) prices.  Those price swings in turn can lead to emotional reactions from investors, which, in turn, lead to emotionally based trading activity. Emotions in this context are bad. More to the point, emotions and investing don't mix as they often result in contra trading behavior. Buying high and selling low, in other words.

In that vein, I have a few friends and relatives that I help with their investing.  The first thing I've tried to gauge with each of them is their tolerance for risk (volatility actually).  I've basically said to all of them some form of the following:  "The market will go up and the market will go down. Sometimes it will go up big and sometimes it will go down big.   Over the long haul though it has always tended to go up.  But if you're going to panic when it goes down, then you shouldn't be in the market"

Warren Buffet has a little different take.  It been said that he advocates, "Being greedy when everyone else is being scared and being scared when everyone else is being greedy."  One interpretation of that philosophy could lead to in-the-moment type reactions.  Panic buys or sells based on market swings, in other words, which could work against the best of long term investment strategies.  Certainly that's not what Mr. Buffet is suggesting.  I think the correct interpretation isn't about greed at all but rather prudence, which requires having a plan and sticking to it.

All that read and understood, are you to conclude that living in the moment is bad?  That depends.  If you're talking about life events outside the investing world, absolutely not.  In those cases, take the advice of proffered in one of my favorite songs (video below) and dance.  

Or take Mr. Sommer's sage advice and, "Live for the moment, but invest for the future."


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