My brother Ian is a huge fan of the 1999 movie Fight Club, particularly the scene where the lead character Tyler, played by Edward Norton, is shown throwing haymaker punches at his own swollen face. Norton’s character is metaphorically battling his materialistic urges. Most investors fight similar battles in a war against themselves.
Much of that internal grappling comes from misunderstanding the stock market. I can’t promise to collar your inner doppelganger. But when you understand how the stock market works—and how human emotions can sabotage the best-laid plans—you’ll become a better investor.
When a 10 Percent Gain Isn’t a 10 Percent Gain
Imagine a mutual fund that has averaged 10 percent a year over the past 20 years after all fees and expenses. Some years it might have lost money; other years it might have profited beyond expectation. It’s a roller coaster ride, right? But imagine, on average, that it gained 10 percent annually even after the bumps, rises, twists, and turns. If you found a thousand investors who had invested in that fund from 1996 to 2016, you would expect that each would have netted a 10 percent annual return.
On average, however, they wouldn’t have made anything close to that. When the fund had a couple of bad years, most investors react by putting less money in the fund or they stop contributing to it entirely. Many investment advisers would say: “This fund hasn’t been doing well lately. Because we’re looking after your best interests, we’re going to move your money to another fund that is doing better at the moment.” And when the fund had a great year, most individual investors and financial advisers scramble to put more money in the fund, like feral cats around a fat salmon.
This behavior is self-destructive. They sell or cease to buy after the fund becomes cheap, and they buy like lunatics when the fund becomes expensive. If there weren’t so many people doing it, we would call it a “disorder” and name it after some dead Teutonic psychologist. This kind of investment behavior ensures that investors pay higher-than-average prices for their funds over time. Whether it’s an index fund or an actively managed mutual fund, most investors perform worse than the funds they own—because they like to buy high, and they hate buying low. That’s a pity.
Morningstar says most investors do this. In a 2014 study, they looked at average mutual fund returns over the 10-year period ending December 31, 2013. The typical fund averaged 7.3 percent per year after fees. The typical fund investor averaged 4.8 percent per year.1
Their fear of low prices prevented them from buying when the funds were low, while their elation at high prices encouraged purchases when fund prices were high. Such bizarre behavior has devastating consequences.
Over a 30-year period, the financial difference would be huge:
$500 invested per month at 7.3 percent a year for 30 years = $641,971
$500 invested per month at 4.8 percent a year for 30 years = $403,699
Cost of irrationality = $238,272
What If You Didn’t Care What the Stock Market Was Doing?
As investors, you really don’t have to watch the stock market to see if it’s going up or down. In fact, if you bought a market index fund for 25 years, with an equal dollar amount going into that fund each month (called “dollar-cost averaging”) and if that fund averaged 10 percent annually, you would have averaged 10 percent or more. Why more?
If the stock market crashes, dollar cost averaging could actually juice returns. Here’s an example.
Assume that somebody started to invest $100 into Vanguard’s US Total Stock Market Index in January 2008. We know what came next: the crash of 2008–2009. You can see it on Figure 4.1. Stocks fell hard in 2008. Part way through 2009, stocks began to recover. But by January 2011, the market was still below its January 2008 level. You can see the chart below.
Figure 4.1 Vanguard’s US Stock Market Index: January 2008–January 2011
Source: © The Vanguard Group, Inc., used with permission
Investors who started to invest in January 2008 might curse their bad luck. But if they stuck to the plan and dollar-cost averaged, they would have done okay.
If they added $100 a month between January 2008 and January 2011, they would have added a total of $3,600. But their investment would have grown to a value of $4,886.2
If the investors had continued to add $100 a month until August 2016 (the time of this writing), they would have added a total of $9,200 since January 2008. Their investment would have grown to $19,228.
By adding equal dollar sums to their index each month, the investors would have bought a greater number of units when the markets were low and fewer units when the market rose. This allowed them to pay a below-average price over time.
Much will depend on the stock market’s volatility. If stocks bounce around a lot, investors who dollar-cost average get rewarded for their discipline—they can actually beat the return of their index. If stock market returns are more stable, someone who dollar-cost averages will still do well—but they won’t beat the market’s return.
Few investors, however, stick to a disciplined plan. Most underperform their funds.
Should You Invest a Lump Sum or Dollar Cost Average?
You’ve inherited a windfall. Should you invest it all at once? Or should you add the money to the markets, month by month, dollar-cost averaging? Nobody knows for sure. But earlier lump sum investments usually win. In other words it’s usually best to invest as soon as you have the money.
A Vanguard case study found that investing a lump sum, as soon as you have it, usually beats dollar-cost averaging. Vanguard compared a series of historical scenarios. They assumed that someone had invested a $1 million lump sum. They wanted to find out if, 10 years later, that investment would have grown higher than if the deposits were spaced out over 6, 12, 18, 24, 30, or 36 months.
Vanguard compared rolling 10-year periods for the US market between 1926 and 2011. They analyzed the same scenario for the UK market (1976–2011) and for the Australian market (1984–2011). Lump sum investing won 67 percent of the time. It’s usually best to invest as soon as you have the money.
Most Investors Exhibit Nutty Behavior
Combine the crazy behavior of the average investor with the fees associated with actively managed mutual funds. The average investor ends up with a comparatively puny portfolio compared with the disciplined investor who puts in the same amount of money every month into index funds. Table 4.1 categorizes investors who will be working—and adding to their investments—for at least the next five years.
Table 4.1 The Average Investor Compared with the Evolved Investor
The Average Investor The Evolved Investor
Buys actively managed mutual funds. Buys index funds.
Feels good about his or her fund when the price increases so buys more of it. Buys equal dollar amounts of the indexes and knows, happily, that this buys fewer units as the stock market rises.
Feels bad about his or her fund when the price decreases, so the person limits purchases or sells the fund. Loves to see the stock index fall in value. If he or she has the money, the person increases purchases.
I’m not going to suggest that all indexed investors are evolved enough to ignore the market’s fearful roller coaster while shunning the self-sabotaging caused by fear and greed. But if you can learn to invest regularly in indexes and remain calm when the markets fly upward or downward, you’ll grow far wealthier. In Table 4.2, you can see examples based on actual US returns between 1980 and 2005.
Table 4.2 Historical Differences Between the Average Investor and the Evolved Investor
The Average Investor The Evolved Investor
$100 a month invested from 1980 to 2005 in the average US mutual fund (roughly $3.33 a day). 10% annual average. $100 a month invested from 1980 to 2005 in the US stock market index (roughly $3.33 a day). 12.3% annual average.
Minus 2.7% annually for the average investor’s self-sabotaging behavior. No deficit for silly behavior.
25-year average annual return for investors: 7.3% 25-year ave
rage annual return for investors: 12.3%
Portfolio value after 25 years = $84,909.01 Portfolio value after 25 years = $198,181.90
Note: Although the US stock market has averaged about 10 percent annually over the past 100 years, there are periods where it performs better and there are periods where it performs worse. From 1980 to 2005, the US stock market averaged slightly more than 12.3 percent a year.3
The figure on the left side ($84,909.01) is probably a little generous. The 10 percent annual return for the average actively managed fund has been historically overstated because it doesn’t include sales fees, adviser wrap fees, or the added liability of taxes in a taxable account.
Disciplined index investors who don’t self-sabotage their accounts can end up with a portfolio that’s easily twice as large as that of the average investor over a 25-year period.
Are Index Fund Investors Smarter?
Many financial advisers fall prey to the same weakness. Many like to recommend “hot” funds. They also sometimes think that they can time the market. There’s a US actively managed mutual fund company called American Funds. Investors can’t buy these funds directly. Such funds must be purchased through a financial adviser or broker. You might think that these professionals can advise investors to stay invested and not jump from fund to fund. But that isn’t the case.
Using data from Morningstar, I compared all of the firm’s funds with 10-year track records. I wanted to see how the funds had performed compared to how the funds’ investors had performed.
I examined four fund categories between October 31, 2004, and October 31, 2014. They included US Large Cap, Emerging Markets, Broad International, and Small Cap funds. When averaging investors’ returns in each of the four categories, I found that the American Fund investors underperformed their funds by an average of 1.75 percent per year. If the funds’ investors were rational, they would have earned the same returns as those posted by their funds.
For example, if a fund averaged 10 percent per year over a designated period, then the funds’ investors, over that same time period, should have done the same. But poor behavior (chasing winners, buying high and selling low) cost the American Funds’ investors 1.75 percent per year between October 31, 2004, and October 31, 2014. Once again, investors can’t buy these funds without an adviser. So much for the advisers’ smart guidance!
I made the same category comparisons with the fund company Fidelity. Investors can buy Fidelity’s funds without a financial adviser. But in many cases, financial advisers stuff Fidelity’s actively managed funds into client accounts. Comparing the same four categories over the same time period, Fidelity’s investors underperformed their funds by an average of 2.53 percent per year. As with the American Funds’ investors, they shot themselves in the feet.
Most index fund investors fly solo, without a financial adviser. When I compared the returns of Vanguard’s index fund investors over the same time period in the same four categories, they underperformed their funds by just 0.71 percent per year. Index fund investors didn’t behave perfectly. But they were far less foolish.
I detailed the findings in my December 2014 AssetBuilder article, “Are Index Fund Investors Simply Smarter?”4
Three and a half months later, The Wall Street Journal’s Jonathan Clements published a similar story, “Are Index Fund Investors Smarter?” He asked Morningstar to conduct a broader study. It revealed the same results. Index fund investors appeared to have more discipline. He also offered an explanation:
I suspect it is less about greater intelligence and more about greater conviction. When you buy an index fund, your only worry is the market’s performance. But when you buy an active fund, you have to worry about both the market’s direction and your fund’s performance relative to the market.5
Investors and advisers shouldn’t speculate. They should commit to staying invested. Such discipline, coupled with low-cost index funds, can allow people with middle-class incomes to amass wealth more effectively than their high-salaried neighbors—especially if the middle-class earners think twice about spending more than they can afford.
Even if your neighbors invest twice as much as you each month, if they are average, they will buy actively managed mutual funds. They will also either chase hot-performing funds or fail to keep a regular commitment to their investments when the markets fall. They’ll feel good about buying into the markets when they’re expensive. They won’t be as keen to buy when stocks are on sale.
Don’t be like your neighbors. Avoid that kind of self-destructive behavior and you’ll increase your odds of building wealth as an investor.
It’s Not Timing the Market That Matters; It’s Time in the Market
There are smart people (and people who aren’t so smart) who mistakenly think they can jump in and out of the stock market at opportune moments. It seems simple. Get in before the market rises and get out before the market drops. This is referred to as “market timing.” But most financial advisers have a better chance beating Roger Federer in a tennis match than effectively timing the market for your account.
Vanguard’s Bogle, who was named by Fortune magazine as one of the four investment giants of the twentieth century, has this to say about market timing:
After nearly 50 years in this business, I do not know of anybody who has done it successfully and consistently. I don’t even know anybody who knows anybody who has done it successfully and consistently.6
When the markets go raving mad, dramatically jumping in and out can be tempting. But stock markets are highly irrational and characterized by short-term swings. The stock market will often fly higher than most people expect during a euphoric phase, while plunging further than anticipated during times of economic duress. There’s a simple, annual, mechanical strategy that you can follow to protect your money from excessive crashes, which I’ll outline in Chapter 5. Your investment will still fall in value when the stock market falls, but not as much as your neighbor’s—and that can help you sleep when stocks go crazy.
The strategy that I’ll show you doesn’t involve trying to guess the stock market’s direction. Forecasting where it’s going to go over a short period is like trying to guess which frantic, nightly moth is going to get singed by the light bulb first.
Doing nothing but holding onto your total stock market index fund might sound boring during a financial boom. It might also sound terrifying during a financial meltdown. But the vast majority of people (including professionals) who jump in and out of the stock market end up paying the piper. They often end up buying high and selling low.
What Can You Miss by Guessing Wrong?
Studies show that most market moves are like the flu you got last year or like the mysterious $10 bill you found in the pocket of your jeans. In each case, you don’t see it coming. Even when looking back at the stock market’s biggest historical returns, Jeremy Siegel, a professor of business at University of Pennsylvania’s Wharton School, suggests that there’s no rhyme or reason when it comes to market activity. He looked back at the biggest stock market moves since 1885 (focusing on trading sessions where the markets moved by 5 percent or more in a single day). He tried to connect each of them to a world event.7
In most instances, he couldn’t find logical explanations for such large stock market movements—and he had the luxury of looking back in time and trying to match the market’s behavior with historical world news. If a smart man like Siegel can’t make connections between world events and the stock market movements with the benefit of hindsight, then how is someone supposed to predict future movements based on economic events—or the prediction of economic events to come?
If you’re ever convinced to act on somebody’s short-term stock market prediction, you could end up kicking yourself. Big stock market gains are usually concentrated during just a handful of trading days each year.
During the 20-year period between 1994 and 2013 (5,037 trading days), US stocks averaged a compound annual return of 9.22 percent. But
investors who missed the best five trading days would have averaged just 7 percent per year. If they missed the best 20 days, their average return would have been just 3.02 percent per year. If they missed the best 40 trading days, the investor would have lost money. In Table 4.3, you can see the kind of effect it would have on your money.
Table 4.3 Costs of Speculation, 1994–2013
Average Annual Return
$10,000 Would Have Grown To
Stock Market’s Return 9.22%
$58,352
Best 5 Days Missed 7%
$38,710
Best 20 Days Missed 3.02%
$18,131
Best 40 Days Missed –1.02%
$8,149
Source: IFA Advisors8
Markets can move so unpredictably and so quickly. If you take money out of the stock market for a day, a week, a month, or a year, you could miss the best trading days of the decade. You’ll never see them coming. They just happen. More important, as I said before, neither you nor your broker are going to be able to predict them.
Legendary investor and self-made billionaire Kenneth Fisher, has this to say about market timing:
Never forget how fast a market moves. Your annual return can come from just a few big moves. Do you know which days those will be? I sure don’t and I’ve been managing money for a third of a century.9
The easiest way to build a responsible, diversified investment account is with stock and bond index funds. I’ll discuss bond indexes in Chapter 5, but for now, just recognize them as instruments that generally create stability in a portfolio. Many people view them as boring because they don’t produce the same kind of long-term returns that stocks do. But they don’t fall like stocks do either. They’re the steadier, slower, and more dependable part of an investment portfolio. A responsible portfolio has a certain percentage allocated to the stock market and a certain percentage allocated to the bond market, with an increasing emphasis on bonds as the investor ages.
Millionaire Teacher Page 10