What the hell is quantitative easing? Should I overweight European equities?
Why are people investing in negative yielding sovereigns?
CMBS BBB spreads just widened 20 basis points, should I invest?
Don’t mind the cryptic financial jargon: if you’re a regular investor the answer is I don’t care. The financial sector loves getting itself into a pretzel justifying fees left and right over outperformance*. Asset managers often argue whether the market is frothy/overvalued/rich/bubbly and weave intricate narratives justifying their point of view. An asset manager’s job is to put an investor’s money to best use and it is the financial advisor’s work to keep the portfolio manager under check. Despite the constant bickering, the sector as a whole often forgets that the most important factor for creation of wealth for retail investors is steady savings. The rags to riches stories of day traders investing it all on penny stocks are a dime a dozen (see here or here). Less abundant is the story of the accountant who puts away a set amount each month living within his means. ‘First year analyst invests his bonus into an index tracker for his retirement’ headlined no financial newspaper, ever. Yet, regularly putting aside money is the only sure road to a large diversified asset base. Asset allocation, fund selection and tax efficiency remain important decisions but are secondary to actually having money!
Ben Carlson from A Wealth of Common Sense created a great example of the importance of being a regular saver with Bob the worst market timer ever. From 1970 to 2013, Bob saved 2,000$** a year bumping that up every decade by 2,000$. What makes Bob so terrible is he hoards all his cash and only invests in the S&P 500 right before it collapses. Crashes over his investment period included Black Monday (-34%), the Dotcom bubble (-50%) and the October 2007 Subprime debacle (-52%).
Before revealing the state of Bob’s retirement account, I’d like to zone in on one thing Bob did amazingly well: he stayed invested after crashes. Investing basically boils down to buy low, sell high. Simple enough, no? Not so. Research shows that this is precisely the opposite of what retail investors do. Mom & pop investors are terrible market timers (buy high, sell low) costing them 1-2% annually (whether asset managers are as well is another debate, see footnote 1). They cash-in short term gains incurring high trading costs and turnover while eternally hoping that their losers will have a reversal in fortune***. This asymmetrical treatment of losses and gains is called loss aversion bias. Ingrained in all of us is the desire to cash in quick wins while avoiding the pain of cutting our losses leading us to hold riskier portfolios. Overconfidence in one’s stock picking abilities only exacerbates this bias.
Even with Bob’s market misfortunes, his steady accumulation of savings allowed him to amass over $1.1M in his retirement account for an internal rate of return of roughly 9%. It’s important to note that Bob was lucky enough to begin his retirement when the market is at or near an all time high. Obviously, no one would recommend holding a portfolio completely invested in equities. Those caveats aside, Bob is an excellent example of what an investor should do: invest it, forget it and shift the portfolio towards less risky assets as you age while minimizing fees. The motto loses its jingle near the end, eh? Don’t hesitate to send in suggestions.
Next post will explore some of another aspect of portfolio management: outperformance (read fees).
*Polite conversation forbids mentioning the word outperformance to finance professionals. A future post will focus on this.
**Read more about the assumptions and the example here.
*** Barber, B.M. & Odean, T., 2013. The Behavior of Individual Investors, Elsevier B.V. Available at: http://dx.doi.org/10.1016/B978-0-44-459406-8.00022-6.
***Friesen, G.C. & Sapp, T.R. a, 2007. Mutual fund flows and investor returns: An empirical examination of fund investor timing ability. Journal of Banking and Finance, 31(9), pp.2796–2816.