Here’s a shocking research finding: the average investor earns less than 25% of the returns of the investments they own.
How is this possible? Well, the answer is often found in the mirror. Specifically, and rather embarrassingly, it has a lot to do with the investor’s own unwise behaviour.
Sitting like an 800 pound gorilla in the corner of every investor’s portfolio is an accumulating mass of behavioural based investment mistakes. When the gorilla moves, the results can be costly if not downright devastating.
You’d think the media would be all over this issue, alerting people both to the problem and to effective ways to protect themselves from themselves. There are articles from time to time, notably during times of weak stock markets and financial turmoil, but interest seems to fade when markets surge upward again and people are optimistic (another prime time for investor mistakes, as we’ll discuss in a moment).
So let’s get back to that research finding I opened with. Over longer periods of time, the average investor earns less than 25% of the returns of the investments they own. Various studies covering different time periods have come up with similar results. Let’s apply this research finding to a specific example: let’s say the average equity mutual fund has earned 8% per year over the last 20 years. In this scenario, the average investor in the those funds has earned less than 2% per year. That’s the average investor in the average fund, meaning, of course, that some investors did better, but some did even worse!
Not possible, you might say. All an investor had to do to earn this 8% was to buy an average fund and hold it for 20 years. Well, the simple answer is usually this: the average investor didn’t hold anything for 20 years. Rather, they bought and sold, usually buying high and then proceeding to sell or switch to something else after they didn’t get the quick returns they had hoped for.
Introducing the Behavioural Risk Factor Dial
The way emotions affect investment decisions is rather counterintuitive, so I thought it might help to illustrate the concept with the following sketch.
The evidence shows that your emotions are not a reliable guide to making investment decisions, and this is true whether markets are up or down. When markets start a long slide towards a bear market, investors are full of uncertainty and fear. People make terrible decisions when they are in a state of panic. But the euphoria and unreasonable optimism people feel when the market surges upwards isn’t any better state for making good investment decisions.
Volatility is part of the market and dealing with it effectively can make the difference between reaching your financial goals and the dreams that are attached to them . . . or not. That’s where I see my major role in serving my clients’ best interests and helping them avoid costly mistakes . . . and many have said that is a key reason they deal with me. I see it as my job to maintain a level head and to help my clients maintain their equilibrium as well. In this context, that means not getting overly optimistic when things are good or overly pessimistic when things are bad.
To give you a heads-up when I feel we are heading into a danger zone where there is a high probability of making investment errors, I’m introducing the Behavioural Risk Factor Dial. From time to time, I’ll indicate where I think the needle on the dial is pointing. It’s a subjective approach to gauging the probability of making investment errors in a specific market environment. It’s subjective in that it is based on a personal assessment which takes into account the tone and general direction that the media is taking, and pays attention to conversations I have in the course of my work with current and prospective clients, other investment advisors, and professional advisors in related financial and business fields.
Although there are three coloured sections on this dial, there are only two colours . . . and neither of them is green for ‘go’ or ‘low probability of making mistakes.’ In my experience, there is never a time when investors aren’t prone to making mistakes of some sort. You always need to exercise caution in making investments, and you always need to be alert to where you may be swayed by emotions in your decision-making.
That said, the red zones indicate conditions where there is a high probability of making mistakes and you need to use extreme caution in your decision-making. Although the emotions indicated by the red zones on each side of the dial are polar opposites, optimism and pessimism, the effect on your ability to make good investment decisions is negatively influenced in each case. The negative effect obviously becomes more pronounced as the optimism or pessimism intensifies.
Where are we now?
Based on continued economic pessimism, media negativity and sensationalism and lower than expected stock market returns over the last couple of years, I would say we are in a red zone where there is a high probability of making mistakes. However, the reading has improved significantly over the last 15 months and is no longer “off the chart.”
This week the Financial Post is running its’ 12th annual Junk Science Week. In line with a widely accepted use of the term, the FP describes junk science as occurring “when scientific facts are distorted, risk is exaggerated and the science adapted and warped by politics and ideology to serve another agenda.” Granted that the Financial Post, like all media, also has a certain bent to their writing; but whether or not you usually find yourself in agreement with their take on things, this series makes some interesting points.
As I read Hope Mongering by Terence Corcoran, I was struck by how much of what he says in this article is directly relevant to the field of investment advice. So much so, that I suspect a similar series based on finance would need a much longer run than a week to do the subject justice.
Take the following quote, for instance:
. . . science can also be warped to promote the opposite of fear. Unscientific hope mongering may be just as prevalent as scare mongering. In some ways, the role of the media in hope mongering is more important than in scare mongering. In the hands of journalists bent on doing what they think is socially beneficial work making people aware of new developments, even good science can be twisted, distorted and exaggerated for political purposes.
. . . political and economic turmoil that can develop when science is distorted and used to give citizens false optimism that diseases can be cured and medical conditions reversed. The three examples are the so-called Liberation cure for MS; hyperbaric oxygen chambers to cure autism; and the promotion of trees as a cure for cancer.
The world of investments is riddled with products, strategies and advice that, at their most benevolent, are hope mongering and at their worst can be devastating to your financial health. What marks them as suspect is the fact that they are supported by little—if any—scientific or empirical research which proves that they actually work.
We are not so cavalier with our physical health. We take it for granted that there is a rigorous scientific process in place in the medical field to determine whether a treatment or cure is safe and effective before it is approved for public use. To use an example from Mr. Corcoran’s article, anyone wishing to promote the use of tree bark as a cure for cancer would be required to submit the substance to thorough research. Clinical trials, probably conducted over a period of years, would be necessary to scientifically prove that the treatment would actually help people get better and that any potential benefits outweighed any risks. Before a pharmaceutical company could take the treatment to market, it would face numerous business, logistical and regulatory issues.
It goes without saying that this sort of scientific rigour is not required before financial products and strategies are promoted today. Given the fallout from the recent market turmoil, I find it curious that there isn’t a groundswell of media, financial advisors and pundits who want to take a page from the medical field in this regard.
To apply the concept of junk science to finance, consider the exaggerated claims of the benefits of active management. The question is really whether a professional manager, after all costs, can outperform the market by active stock picking or market timing. The answer history has delivered over longer periods of time is that 80—90% of active managers fail to beat a simple market index. However, hope mongering occurs when the results of the 10–20% of the managers who did beat the market are highlighted. The public perception is that these exceptional results are achievable by the majority of managers; the reality, of course, is that only a small minority do achieve them—smaller than one would expect by random chance alone.
Furthermore, attempting to choose a manager by looking in the rear view mirror—by selecting one who has outperformed in the past—adds little or no value in terms in predicting whether that same manager will outperform in the future. The truth in the small print disclaimer—“past performance is not indicative of future returns”—is backed up by empirical data and science.
When investors are offered the “bark of the financial money tree” as an unsubstantiated cure to financial woes, they should keep in mind that the side effects of the miracle tree bark might do them more harm than the good.
Today investors can draw on vast amounts of scientific and empirical financial data. Using financial science is good for your health. Relying on junk finance—and the hope mongering that supports it—is not.
Long term investment success can be attributed to many factors. One of the most important is very straightforward: avoid making mistakes.
That’s simple, but not easy. How do you avoid making investment mistakes? One approach is to analyze why people generally make mistakes. In researching this question, I came across Joseph Hallian’s book, Why We Make Mistakes. The sub-title of this book is interesting: How we look without seeing, forget things in seconds and are all pretty sure we are way above average.
A key point made in this book is to beware of anecdotes. An anecdote is simply a single observation. At the opposite end of the scale is scientific evidence, which gives the basis of a conclusion based on facts and statistics.
For a common example of how anecdotes are used as evidence, consider how marketers of products generally use testimonials rather than statistics. Think of the last infomercial you saw. Chances are that it was built around many testimonials about how great that particular product was, with no data or facts to back up what was being said.
How does this relate to the investment world? Well, one way of lowering the number of mistakes you make is to disregard anecdotes or hearsay when making investment decisions. An extension of this idea is not to come to any conclusions by generalizing from an insufficient amount of evidence or data.
To take a simple example, let’s say that someone tells you, “My friend Joe is a successful investor. Last year he bought ABC company and made a killing. Last week he said to buy XYZ company.”
Should you buy XYZ company?
There are two ways of looking at this. The first is behavioural. If Joe is like most of us, it is unlikely he would admit to his past mistakes, because that would suggest he isn’t “way above average” (and we all think we are way above average!) As a result, it is unlikely you would ever hear about his bad picks, just his good picks.
The second approach is fact-based. It is highly unlikely that you would know Joe’s stock picking track record, so no one can determine whether he is “successful” or not. Even if we assume that he is successful based on this one observation, there isn’t enough data to determine whether his success is based on luck or skill. In the absence of data, it is best to assume he was just lucky!
From a factual standpoint, there is a great deal of data that tries to determine what the experience of a “typical investor” might be. There are hundreds of reports to choose from, but I will highlight two. First, a paper by Barber & Odean at the University of California (Just How Much do Investors Lose by Trading), showed that individual investors in aggregate underperformed professional or institutional investors by 4% annually. Second, research conducted by S&P, using mutual fund data as a proxy, found that only 7.4% of professional managers outperformed the TSX Index over the last 5 years (2009 S&P SPIVA report).
Now ask yourself the following question. If individuals underperform professionals by a wide margin, and 93% of professional underperform the simple stock market index, what is the probability of an individual picking his or her own stocks doing better? Slim, at best.
Stories are powerful and it’s human nature to pay attention to anecdotes. It’s easier than making decisions based on analysis of facts and evidence. Marketers of financial products know how to play on this human weakness as well as the makers of late night infomercials. They use anecdotes and appealing visuals—a retired couple walking on the beach, and so forth—to bypass our reason and sell their products based on an emotional response.
To sum up, successful investors (and advisors) rely on facts and not anecdotes. An investment strategy that relies on anecdotes is flawed and has a low probability of success. A strategy based on science and empirical data requires skill and knowledge, but ultimately gives investors a higher probability of investment success.
There is a tremendous amount of noise and rhetoric around common share dividends. So much so that I could write numerous pieces on this subject!
Recently, the dividend rhetoric reached a new crescendo level when Manulife Financial announced they were cutting their dividend in half. Given the comments in the press by some of Canada’s most recognizable money managers, I am surprised that a Royal Commission wasn’t called to investigate.
Let’s step back to see exactly what a dividend is.
When any public corporation makes a profit, they have two choices of what to do with that cash:
i) re-invest it back into the business, or
ii) return it to shareholders through cash dividends or share repurchase plans.
This is a fairly simple concept but, unfortunately, widely misunderstood. Here are a couple of points to consider:
• Dividends are paid from “profits” – if a corporation is not making profits, then money paid out in dividends is from its own capital. For example if a company is not profitable, yet is paying out 10% per year in dividends, investors are just receiving back their own money like an annuity.
• If a company decides to have a policy of keeping profits in the business and not paying out dividends, that money still stays in the business. It doesn’t make a company less valuable if it keeps the profits in the business rather than paying them out as dividends.
• From a tax perspective, it is actually more beneficial for a taxable investor if a company uses share re-purchase plans instead of dividends. The monetary benefit is identical between the two, however dividends are taxable in the year they are received. Whereas, the benefit of share repurchase plans is more tax advantaged deferred capital gains.
These concepts aren’t new. In fact a research paper written almost 50 years ago addressed the concept of dividends:
Like many other propositions in economics, the irrelevance of dividend policy … is “obvious, once you think of it.” … (Company) Values are determined solely by “real” considerations – in this case the earning power of the firm’s assets and its investment policy – and not by how the fruits of the earning power are “packaged” for distribution.
“Dividend Policy, Growth, and the Valuation of Shares”, Merton Miller and Franco Modigliani, Journal of Business, 1961
What is the bottom line? In the long run stock values are driven by corporate profitability. Whether a company decides to payout those profits as dividends is irrelevant. So, dividends do not and should not matter to investors.
Financial News Media . . . Entertainment or Education?
Dec 16, 2009 5:18 PM Steve Lowrie
From time to time clients ask us questions about financial information they have either seen on television or read in newspapers and magazines. Recently, most of the questions have been related to the massive federal budget deficits of the United States and the effect this might have on the US dollar, US equities, Canada, gold and other commodities. While this maybe the current "crisis de jour", we should point out that any pundit talking about what has already happened always sounds very convincing.
While we recognize that there are many hard-working and diligent individuals in the financial news industry, we nevertheless advise our clients and contacts to be very wary about how they filter the information they receive from financial news sources.
Distinguishing reliable from unreliable news can be difficult. Bold market predictions, stock suggestions and "sure-fire" investment tips coming from the financial media are packaged to make them seem like smart investment advice.
There is an element in the financial media who portray themselves to an unsuspecting audience as sellers of health-building vitamins, to use a medical analogy, when they are actually selling useless (or even potentially harmful) snake oil.
Our advice has always been to examine the motives of those offering "predictions and tips" and to recognize that, more often than not, the financial information being received (if acted upon) can do far more damage than good.
The clip below is intended for entertainment purposes, but there is a lesson to be learned in the underlying message. Too bad it takes Comedy Central to unearth the dirt. Before you open the link please note that some viewers may find the language objectionable - please be forewarned! This is an 8 minute clip from Jon Stewart's comedy show, where he takes on the financial media powerhouse CNBC.
• Risk and return are related
• A successful, long-term investment approach includes tuning out the "investment hype"
• Trying to pick a couple of winning stocks is a waste of time and money (short or long term) - diversification is your friend
• Unlike gambling, real investing is not a game. Its purpose is not to have fun or entertain you.
I hope you find the video as entertaining and as educational as I did.
When the news these days is screaming “Market Meltdown!”, it seems as if everyone is rushing for the exits and selling stocks in a panic. It’s easy to forget that every trade involves both a seller and a buyer. It might make you wonder, with so much negative economic news being announced daily, who is buying, and why now?
The short answer is: it’s the so-called “Smart Money”, those investors who see the current bad environment as a temporary opportunity to acquire valuable assets at great prices.
We are not making light of the intestinal fortitude it takes to be buying stocks in the current environment. But truthfully, careful analysis of daily stock market action reflects that much of the selling is either forced or involuntary (which we discuss below) or it is driven by strong emotional sentiment. Buying, on the other hand, is driven by different motives. Buyers simply see the glass as being half full, not half empty. And regardless of whether the daily market drama might continue for some time, they are basing their decisions on the rules of fundamental value. They are buying stocks because they believe their patience and foresight will ultimately reap rewards.
So, raise your half-empty glass and consider whether perhaps it might actually be half full. Here are a few reasons to think so:
Market Volatility Creates Opportunity
Highly-leveraged investors, such as investment banks, hedge funds and brokerage houses, have no choice but to reduce their leverage. In fact, their forced selling has become the norm recently, especially near the end of the trading day. Involuntary sellers care less about price and more about needed liquidity, so they take almost any (mostly low) price available. That is why wild negative volatility has frequently been so dramatic in the last hour of trading. It certainly has nothing to do with fundamental value. The flip side is that this volatility is this: it creates a tremendous buying opportunity for patient, long-term investors. In fact, as providers of liquidity, they are accumulating stocks at excellent prices.
Recent G20 Meeting
A very encouraging sign from the recent G20 meeting is that there is unprecedented co-operation among countries to do whatever it takes to reboot the global economy. For example, they have agreed not to impose any new trade tariffs for the next 12 months, thus maintaining a free flow of goods and capital.
Global Monetary Stimulus from Central Banks
Central banks around the world are lowering interest rates and increasing their money supply. These lower borrowing costs are being passed on, not only to banks, but also to businesses and consumers. This effort supports and builds demand for goods and services in the economy. And, they can cut interest rates further if need be.
Global Fiscal Stimulus
Governments around the world have announced billions of dollars in new spending. Such spending, whether for infrastructure projects or help for banks and industry, will help stimulate overall economic activity. It is also encouraging to see the speed with which these plans are being undertaken. Quick action will speed up the time frame for an eventual recovery.
Valuations
In previous commentaries, we have discussed the fact that equity valuations are at the lowest levels in decades. There are various metrics related to valuations, such as price/earning ratios, price/book value ratios, etc. Of particular interest lately is dividend yield. For example, recently, the dividend yield of the stock market has increased to a level above the 5-year government bond. This is the first time that has happened since 1957!
Historic Bull/Bear Markets
Research on previous bear markets in global stock markets suggests that they typically last 13 months, with a decline of 24%. The current bear market is more severe: it has now lasted 21 months and has declined over 33%. Nevertheless, and we take no comfort in saying so, the recent bear market is not without precedent. More importantly, the recoveries from bear markets have lasted an average 44 months with average returns of 133% This is not a forecast that a market bottom has been reached, but, it is now a waiting game: the longer a bear market persists, the closer the next bull market inevitably is. Think half full.
In conclusion, let us say we fully appreciate the anxiety that this recent market downturn is causing many investors. Frankly, some of the day-to-day volatility is astonishing and the best experts are at a loss to explain it. It doesn’t really make much sense from an economic perspective, for it is extremely unlikely that future corporate profitability, which drives stock prices over the long run, will prove to be even remotely as volatile as the recent stock market volatility would suggest.
Not to sound like a broken record, but we can only say again: patient investors will eventually be rewarded handsomely for staying the course during this most time.
No doubt you've seen a lot of news lately concerning the extremely volatile situation in global financial markets. These negative economic reports overlaid against an uncertain political environment tend to make some of us anxious, even fearful about the future. We may become concerned about the security of our jobs or the value of our real estate and investment assets. And the media's sensational barrage of "Breaking News" on a 24/7 basis doesn't help to keep things in perspective. Indeed, the media thrives on portraying the current environment as though the sky were truly falling.
This leads to a very fundamental question regarding global financial markets: "Is this time different?" We plan to address that question shortly and in some detail in our quarterly notes, but in the meantime, have no doubt that we, like you, take recent events very seriously. We believe that central banks and other decision makers will succeed in finding solutions to restore confidence to the marketplace, but the day-to-day gyrations are unnerving to say the least. We are attaching a brief presentation by Weston Wellington of Dimensional Fund Advisors, who does a great job of providing some perspective for today's markets. We highly recommend you take a few minutes to review his comments:
On a separate note, during times like these we often get asked if our phones are ringing off the hook, the implication being that clients are panicking. This is not the case. In fact, we have been having just as many conversations with clients looking to invest additional capital as from those troubled by recent market volatility.
Now that the bear is once again stalking the world’s stock markets, frustrated investors are having their patience tested. Some are alarmed enough to ask, “Could stock markets be ‘broken’? Should I reconsider owning stocks altogether?” We are not immune to these concerns, but we know such questions must be answered by looking deeper and viewing recent events in historical context. Our assessment is that discipline and fortitude in the weeks and months ahead will ultimately be rewarded.
We start with the question, “Do current equity returns compare to other negative cycles?” In answer, we have looked back at returns (both positive and negative) of Canadian stocks over the last 50 years. Technically, a bear market is present once a cumulative loss occurs of at least 20% from a high point. We examined periods when the Canadian stock market had a cumulative gain (loss) from a low (high) point of at least 10%. Such market cycles are easily identified after the fact by using historical cumulative monthly returns.
Here is what we found:
Bull Markets: Average duration 26 months, Average Advance +75%
Bear Markets: Average duration 8 months, Average Decline –21%
These important observations are clear:
1) The average duration of a bull market is three times longer than that of a bear market and the average upward advance is three and a half times more. In other words, bull markets have lasted much longer than bear markets and delivered gains that are disproportionately greater than the bear market losses.
2) Any trends are not easily defined until after the fact. Practically speaking this means that it is not known whether a bull or bear market is established until after it has already happened. This reality points to the difficulty anyone will have in trying to accurately forecast or time market cycles.
3) When reversals occur, they are usually fast and large in magnitude. Share prices “gap up” just as quickly as they “gap down”.
How can we incorporate these facts into the current environment?
World stock markets (measured by MSCI) have declined approximately 20% since the highs reached ten months ago. Canadian stocks (measured by the TSX Composite) are off approximately 20% since highs reached in early June. These amounts are in line with historical bear market averages. While we take no comfort in this fact, it would indicate the worst is probably behind us.
We have discussed our outlook in depth in the last quarterly notes. However, one point worth repeating here is that valuations for stocks are now the lowest they have been in decades (MSCI World trading at only 12 times forward earnings). Lower valuations have historically pointed to higher future returns.
Of course, what everyone wants to know is, “What will be the catalyst for turning things around this time?”
No one has that answer, but experience has taught us that the market will turn around well in advance of any improvement in the “real” economy – probably dramatically and when it is least expected. As hard as it may seem, the best advice during a bear market is to keep emotion out of the equation and stay on course. And focus on the fact that bull markets exist 75% of the time.
