In the summer of 1885 William R. Travers, prominent NYC businessman and builder of Saratoga Race Track, was vacationing in Newport, Rhode Island. He pointed out a long line of beautiful yachts tied up in the harbor. When he was informed that they all belonged to Wall Street brokers he simply asked, "Where are their clients' yachts?"
When it comes to investing, there is nothing more dangerous to an individual's future outcomes than falling prey to the many myths conveyed by Wall Street. The investment business is, after all, just that: a business.
What Wall Street has learned, as the days of commission-based trading have been relegated to computerized trading, is that fee-based management is a very profitable annuitized business model.
The only trick is keeping individuals fully invested at all times so fees can be collected.
This need has generated some of the biggest "myths" in the investment world to keep investors piling money into mutual funds, hedge funds and advisory accounts.
Here are 5 myths worth thinking about:
1) Stay Invested, as the Market Always Returns 10 Percent
You have heard this one plenty: "Over the long-term” the stock market has generated a 10 percent annualized total return. So, just plunk your money down and you will be wealthy.
The statement is not entirely false. Since 1900, stock market appreciation plus dividends has provided investors with an average return of 10 percent a year. Historically, 4 percent, or 40 percent of the total return, came from dividends alone. The other 60 percent came from capital appreciation that averaged 6 percent and equated to the long-term growth rate of the economy.
However, there are several fallacies with the notion that the markets long-term will compound 10 percent annually.
- The market does not return 10 percent every year. There are many years where market returns have been sharply higher and significantly lower.
- The analysis does not include the real world effects of inflation, taxes, fees, and other expenses that subtract from total returns over the long-term.
- You don’t have 144 years to invest and save.
A $1,000 investment from 1871 to present including the effects of inflation, taxes and fees shows the difference. (I have used a 15 percent tax rate on years the portfolio advanced in value, CPI as the benchmark for inflation and a 1 percent annual expense ratio. In reality, all of these assumptions are quite likely on the low side.)
From 1871 to present the total nominal return was 9.07 percent versus just 6.86 percent on a “real” basis. While the percentages may not seem like much, over such a long period the ending value of the original $1,000 investment was lower by an astounding $260 million dollars.
Importantly, as stated previously, and as I will discuss more in a moment, the return that investors receive from the financial markets is more dependent on the “when” you begin investing.
2) I Can Beat/Outperform the Stock Market
No, you can't and the data prove it.
Dalbar recently released their 21st annual Quantitative Analysis Of Investor Behavior study which continues to show just how poorly investors perform relative to market benchmarks over time and the reasons for that under performance.
It is important to note that it is impossible for an investor to consistently “beat” an index over long periods of time due to the impact of taxes, trading costs, and fees. Furthermore, there are internal dynamics of an index that affect long term performance which do not apply to an actual portfolio such as share repurchases, substitution, and replacement effects.
However, even these issues do not fully account for the underperformance of investors over time. The key findings of the study show that:
- In 2014, the average equity mutual fund investor underperformed the S&P 500 by a wide margin of 8.19 percent.The broader market return was more than double the average equity mutual fund investor’s return. (13.69 percent versus 5.50 percent).
- In 2014, the average fixed income mutual fund investor underperformed the Barclays Aggregate Bond Index by a margin of 4.81 percent. The broader bond market returned over five times that of the average fixed income mutual fund investor. (5.97 percent versus 1.16 percent).
- Retention rates are slightly higher than the previous year for equity funds and increased by almost six months for fixed income funds after dropping by almost a year in 2013.
- In 2014, the 20-year annualized S&P return was 9.85 percent while the 20-year annualized return for the average equity mutual fund investor was only 5.19 percent, a gap of 4.66 percent.
- In eight out of 12 months, investors guessed right about the market direction the following month. Despite “guessing right” 67 percent of the time in 2014, the average mutual fund investor was not able to come close to beating the market based on the actual volume of buying and selling at the right times.
Most importantly, despite what Wall Street and advisors want you to believe, 50 percent of the shortfall was directly attributable to psychology — both theirs and yours. The other 50 percent came down to lack of capital to invest.
So, the next time you hear the mainstream media chastise investors for not beating some random benchmark index, just realize they didn't either.
3) Your Financial Plan Says You Will Be Just Fine
One the biggest mistakes that investors make are in the planning assumptions for their retirement:
4) If You're Not In, You're Missing Out
- There is a massive difference between compounded returns and real returns as shown. The assumption is that an investment is made in 1965 at the age of 20. In 2000, the individual is now 55 and just 10 years from retirement. The S&P index is actual through 2014 and then projected through age 100 using historical volatility and market cycles as a precedent for future returns.
- While the historical average return is 7 percent for both series, the shortfall between 'compounded' returns and 'actual' returns is significant. That deficit is compounded further when you begin to add in the impact of fees, taxes and inflation over the given time frame.
- The single biggest mistake made in financial planning is not to include variable rates of return in your planning process."
- Look at your financial plan projections. If they are a smooth curve upwards, you are going to be very disappointed.
It is often said that you should remain invested in the markets at all times because there has never been a 10-year period that has produced negative returns for investors. That simply isn’t true.
OK, but over 20 years, investors have never lost money, right? Not really.
There are two important points to take away from the data. First, is that there are several periods throughout history where market returns were not only low, but negative. Secondly, the periods of low returns follow periods of excessive market valuations.
In other words, it is vital to understand the “when” you begin investing that affects your eventual outcome.
From current levels history suggests returns to investors over the next 20-years will likely be lower than higher. We can also prove this mathematically.
Capital gains from markets are primarily a function of market capitalization, nominal economic growth plus the dividend yield. Using John Hussman's formula we can mathematically calculate returns over the next 10-year period.
If we assume that GDP could maintain 4 percent annualized growth in the future, with no recessions, and if current market cap/GDP stays flat at 1.25, and if the current dividend yield of roughly 2 percent remains, we get forward returns of:
(1.04)*(.8/1.25)^(1/10)-1+.02 = 1.5 percent
Regardless, there are a "whole lotta ifs" in that assumption. More importantly, if we assume that inflation remains stagnant at 2 percent, as the Fed hopes, this would mean a real rate of return of -0.5 percent. This is certainly not what investors are hoping for.
5) You Can’t Time the Market – Just Buy and Hold
There are no great investors of our time that "buy and hold" investments. Even the great Warren Buffett occasionally sells investments. Real investors buy when they see value, and sell when value no longer exists.
While there are many sophisticated methods of handling risk within a portfolio, even using a basic method of price analysis, such as a moving average crossover, can be a valuable tool over the long term holding periods. Will such a method always be right? Absolutely not. However, will such a method keep you from losing large amounts of capital? Absolutely.
The actual moving averages used are not relevant, but what is clear is that using a basic form of price movement analysis can provide a useful identification of periods when portfolio risk should be reduced.
Importantly, I did not say risk should be eliminated; just reduced.
Again, I am not implying, suggesting or stating that such signals mean going 100 percent to cash. What I am suggesting is that when "sell signals" are given that is the time when individuals should perform some basic portfolio risk management such as:
- Trim back winning positions to original portfolio weights: Investment Rule: Let Winners Run
- Sell positions that simply are not working (if the position was not working in a rising market, it likely won't in a declining market.) Investment Rule: Cut Losers Short
- Hold the cash raised from these activities until the next buying opportunity occurs. Investment Rule: Buy Low
The reason that portfolio risk management is so crucial is that it is not "missing the 10-best days" that is important; it is "missing the 10-worst days."
Avoiding major drawdowns in the market is key to long-term investment success. If I am not spending the bulk of my time making up previous losses in my portfolio, I spend more time growing my invested dollars towards my long-term goals.
Chasing a Unicorn
There are many half-truths perpetrated on individuals by Wall Street to sell product, gain assets, etc. However, if individuals took a moment to think about it, the illogic of many of these arguments are readily apparent.
Chasing an arbitrary index that is 100 percent invested in the equity market requires you to take on far more risk that you realize. Two massive bear markets over the last decade have left many individuals further away from retirement than they ever imagined. Furthermore, all investors lost something far more valuable than money - the TIME needed to achieve their goal.
To win the long-term investing game, your portfolio should be built around the things that matter most to you.
A rate of return sufficient to keep pace with the rate of inflation.
Expectations based on realistic objectives. (The market does not compound at 8 percent, 6 percent or 4 percent every year, losses matter)
Higher rates of return require an exponential increase in the underlying risk profile. This tends to not work out well.
You can replace lost capital — but you can't replace lost time. Time is a precious commodity that you cannot afford to waste.
Portfolios are time-frame specific. If you have a 5-years to retirement but build a portfolio with a 20-year time horizon (taking on more risk) the results will likely be disastrous.
The index is a mythical creature, like the Unicorn, and chasing it has historically led to disappointment. Investing is not a competition, and there are horrid consequences for treating it as such.
So, the next time a financial professional encourages you to just "buy and hold" for the long-term, maybe you should question just who's "yacht" are you buying?
is a chief portfolio strategist and economist for Clarity Financial. To read more of his commentary, CLICK HERE NOW.
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