As a client of MASECO you would have heard us talking about the equity market return premium, which states that the equity markets have outperformed the risk-free rate of return (for USD benchmarked investors: one month treasury bills) over time by a significant margin. The graph below is a nice long term illustration of this:
Professor Richard H. Thaler of the School of Business at the University of Chicago has been awarded the Nobel Prize in Economics for his work within behavioural finance. This is the second time a behavioural finance economist has won the prize since Daniel Kahneman in 2002.
Most major languages have their own version of the idiom “Shirtsleeves to Shirtsleeves in three generations”. From the very literal Chinese “wealth never survives three generations” to the more musical Italian “dalle stalle alle stelle alle stalle” (from the stalls to the stars to the stalls), this is a phenomenon that has existed for centuries. However, I believe that in our industry it is poorly understood, continuously under-studied and rarely discussed with clients.
At MASECO we are strong believers in focusing our efforts on controlling what we can and optimizing the chances for success over what we cannot control.
Arguably the most important factor we should be able to control is our behavior through the market cycles, but as most experienced investors know this is easier said than done.
Perhaps the most famous study on investors’ average returns compared to the market is the DALBAR study, which found that over the last 30 years equity fund investors achieved an average return of 3.79% against the index return of 11.06% and the average fixed income fund investor achieved 0.72% against an index return of 7.36%. Inflation was 2.70% over the period. Fund fees can explain some of the underperformance, but the vast majority is down to bad market timing decisions. The investor is his own worst enemy – why is this?
A lot of research has been done on this and it is essentially down to what John Maynard Keynes called ‘animal spirits’ that overpower our logical better knowledge in situations of stress.
However, perhaps the more helpful question is what can we do about it? Well the first step is to engage a good wealth manager that can guide you through highs and lows, but education is also powerful. I am a big fan of TED talks and recently watched a talk about using mindfulness to beat addiction and compulsive behavior. I think it translates very well to investing and is well worth a watch.
‘The value of an investment and the income from it could go down as well as up’. You may not get back the full amount of your original investment. Past performance is not an indicator of future performance.
Millennia of evolution has ingrained in us many psychological traits that has served us well as a species, but that works against us when investing. Some of these traits are;
- Herding. Copying the behaviour of others even in the face of unfavourable outcomes.
- Loss Aversion. Expecting to find high returns with low risk.
- Chasing past returns and anchored views. Investors typically focus on the best investments and investment managers over the last five years or less, which can lead some to invest in expensive assets with lower expected returns than cheaper out of favour investments.
- Narrow Framing. Making decisions without considering all implications.
So how badly have average investors fared compared to the markets?
Many of our clients are familiar with DALBAR’s annual Quantitative Analysis of Investor Behaviour (QAIB) study, where DALBAR analysed cash flows in and out of mutual funds to calculate investor’s average net investment returns. The latest report covers the period from Jan 1st ‘1985 to Dec 31st 2014 and paints a similar picture to earlier studies. Here are the key findings:
- Over the period the S&P500 returned 11.6% pa, the Barclays Aggregate Bond Index Returned 7.36%pa, and inflation was 2.70%pa.
- Equity investors achieved 3.79% per annum on average, barely ahead of inflation.
- Fixed Income investors achieved 0.72%, almost 2% behind inflation.
- Costs and poor management contributed to the underperformance, but poor decision making was likely the primary detractor from average investor returns.
The results are a valuable reminder that trying to predict the future can have an overwhelmingly negative effect on investors’ investment experience, and that identifying the right asset allocation and sticking to it may provide the highest odds for a favourable outcome.
Warren Buffet probably summarized this the best when he said; “Investing is simple, but not easy.”
Stop being distracted by the endless media noise and spend your spare gadget time on something more productive!
I recently ran out of battery on my mobile phone and was left waiting for my friend in a bar for 15 minutes. Shock, horror! I had no idea what to do with myself. Eventually my nerves settled and a great by-product of not having a distraction manifested itself, I spent some time alone with my brain. More specifically, I reflected on how dependent we are on our gadgets these days and, despite what we may think, how much time we spend procrastinating on these devices.