Albert Einstein famously said that “Insanity is doing the same thing over and over again and expecting different results.”
For years and years, the American investor has faithfully invested money into the stock market. Since 1916, the market’s long term average is still hovering around 10% per year. That sounds pretty good. Why then has the average American investor so consistently achieved investment returns far below market averages, year after year after year? For example, from 1991 to 2010 the S&P 500 earned 9.14%. Not too shabby. However, the average equity fund investor only earned 3.83% over this same time period. (Source: 2011 QAIB Dalbar Study) What’s going on here? Why does the average individual investor typically end up doing so much worse than the benchmarks? Many institutions have been consistently outperforming the benchmarks by a substantial margin and doing so while taking on less risk. What are the individual investors doing wrong and what are these institutions doing right?
Many individual investors have read advertising or literature calling attention to the consistent underperformance of individual investors and also most actively managed approaches. This “fact” is commonly used as supporting evidence of why investors should embrace low-cost, passively managed strategies. The rationale goes something like this: “Since 80% of those utilizing actively managed strategies don’t beat the benchmark, investors should just adopt inexpensive passively managed strategies that seek to duplicate a specific benchmark or index.”
It sounds logical, right? This statement is a bit misleading because in reality, no prudent investor would even consider adopting a particular actively managed strategy that has a consistently horrendous long-term track record—yet these same approaches are included in the universe of strategies that don’t beat the index. Another thought to consider is, “What about the 15% of strategies that do beat the index?” What if a hypothetical actively managed strategy consistently outperformed its corresponding benchmark or index? Should such a strategy be categorically dismissed since it’s not a low-cost, passively managed strategy? That wouldn’t make any sense either. Both low-cost, passive strategies that seek to duplicate an index as well as actively managed strategies can play an important role in a diversified portfolio.
The bottom line is that there are reasons for using low-cost, passively managed strategies for certain asset classes and there are reasons not to use them in other asset classes. Efficient market theory goes beyond the scope of this article. However, one thing is for sure: utilizing an inexpensive, passively managed strategy does not mean that an investor must adopt a buy-and-hold methodology. “Don’t miss the 10 best days” is a perfect example of this flawed line of reasoning. Many investors have been encouraged to adopt a buy-and-hold methodology and cite the statistical fact that if you miss the 10 best days of the market, your return is drastically diminished. While this is technically true, it does not tell the whole story. The Journal of Financial Planning featured the results of a pertinent study done by Paul Gire. In a nutshell, the study looked at the market’s history and revealed that the 10 best days of the market were typically during times of heightened volatility.
What’s fascinating is that in general, these 10 best days were in curiously close proximity to the 10 worst days of the year—which also typically occurred during these periods of heightened volatility. The study further revealed that an investor that was willing and able to give up the 10 best days of the year in exchange for missing the 10 worst days of the year would have enjoyed substantially better performance than the “buy and hold” investor that got both the 10 best and the 10 worst. Additionally, this outperformance would have been achieved with substantially less volatility. This study highlighted a very important investment concept that the institutions I will discuss know very well: Loss avoidance during down markets is more important than gain capturing during up markets. An investor with $100,000 only needs to earn 50% in order to gain $50,000. However, if this same investor suffered a 50% loss, he/she now must earn 100% in order to earn the same $50,000 and get back to where he/she started (which could take years).
Harvard University and Yale University are two exemplary institutions that have taken the science of investing very seriously. Do these institutions follow a strict “buy and hold” methodology? No. To the contrary, they are uncomfortable with the degree of risk that this methodology presents and utilize a different methodology in managing their respective endowments. These institutions utilize an investment methodology called “Tactical Asset Allocation,” which involves asset class diversification tactics and active portfolio management. This methodology takes advantage of both low-cost, passively managed strategies seeking to duplicate an index as well as active management. How has utilizing this methodology worked out for Harvard and Yale?
For the period between 1985 and 2008 (endowment fiscal year ends June 30th) the Yale University endowment has returned 16.62% per year. (Yes, you read that correctly.) “Not only did the Yale endowment outperform the S&P 500 by over 4.5% per year, but it did so with less volatility and only one losing year (a tiny -0.02% in 1988). A $100,000 investment in the Yale endowment in 1985 would be worth $4 million by June 30, 2008 versus only $1.5 million invested in the S&P 500 and only $900,000 in U.S. 10-year government bonds. The same amount invested in Harvard University’s endowment would be worth a respectable $3 million.” (Source: Mebane T. Faber & Eric W. Richardson—The Ivy Portfolio; NACUBO.org.) It should be noted that these endowments have billions of dollars and have access to some investments that the average investor would not. Nonetheless, the strategies used by these endowments can be effective for an investor with $10,000, $100,000, $1 million or even billions. The concepts are the same which are grounded in sound logic and statistics. Of course, no system guarantees that you will never lose money. Neither tactical asset allocation’s past success nor any methodology’s past success is a guarantee of future performance. Even these sophisticated endowments have lost money in some years.
Many reading this article may be thinking, “Why doesn’t everyone do this?” The simple answer to that question is that unlike institutions, most individual investors are unaware of this investment methodology and for those that become aware, most don’t have sufficient financial training and expertise to design and manage a portfolio that employs tactical asset allocation. This illustrates a fundamental principal of financial planning: It’s critically important to stick to what you are good at. Many of my clients are professionals, business owners, and trustees of corporate retirement plans (401K, 403B, profit-sharing plans, etc.). If I tried to do what they know how to do and for example, tried to give myself a root canal, I would end up in the hospital and in a great deal of pain. I have no training in surgery and my 20 years of financial training and experience will not help me whatsoever to successfully conduct a root canal. My clients understand that this concept is universal. They may be very good at what they do, but they recognize that being great at medicine or law or even business doesn’t carry over to being great at financial planning or tactical asset allocation. That’s why they choose to have me do this for them and why I choose to leave root canal to the medical professionals.
My advice to frustrated investors: Don’t give up. Remember what Albert Einstein said. If what you have been doing is not producing the results you desire, consider a different approach. If you feel that you may be taking on more risk than you should be—yet also acknowledge the importance of growing your assets, investing the time to learn more about your options may be the best investment you will ever make.
Kevin Ross is an award-winning and practicing financial advisor with Innovative Wealth Partners, LLC, an affiliate of Delaware Valley Financial Group. Mr. Ross was voted a Five Star Wealth Manager in 2010 and again in 2011 as featured in both years in the November edition of Philadelphia magazine. Mr. Ross sees clients and prospective new individual and corporate clients by appointment only and can be reached at 610-668-1400 or at kevinross@iwpweb.com.
Disclosures: Past performance is no guarantee of future results. Securities/advisory services offered through Financial Network Corporation - member FINRA & SIPC. Branch address: 1021 W. 8th Ave. / King of Prussia, PA 19406 / Phone: 610-668-1400. Innovative Wealth Partners, LLC is not affiliated with Financial Network Investment Corporation.
The 5 Star Wealth Management Award identifies those that must have a minimum 5 years experience in the financial services industry and receive certification that they have been reviewed for regulatory actions, civil and judicial actions and customer complaints. Details of the Five Star Wealth Management Award can be viewed at www.fivestarprofessional.com. Recognition from rating services or publications are no guarantee of future investment success. Working with a highly rated financial advisor does not ensure that a client or prospective client will experience a higher level of performance or results. These ratings should not be construed as an endorsement of the financial advisor by any client nor are they representative of any one client's evaluation.
