“I never blame myself when I’m not hitting. I just blame the bat, and if it keeps up, I change bats. After all, if I know it isn’t my fault that I’m not hitting, how can I get mad at myself?” – Yogi Berra
I have spent a lot of time talking up the advantages of investing in index funds. The benefits of investing in index funds become clear when compared to actively managed mutual funds.
There are a number of reasons that the Wall Street pros don’t spend much time pushing index funds on their clients. The simple reason is that they earn more money selling complex or expensive funds to investors.
But another reason is that many in the finance industry are overconfident and fail to admit that over time it becomes very difficult to beat the market’s return. There are definitely skilled investors out there, but excessive fees and transaction costs make it very difficult to outperform simple low-cost index funds on a consistent basis.
So when I found a Wall Street veteran who was willing to share his honest assessment on this subject I thought it would be worth sharing. In a Business Insider article last week, an investment strategist named Gerald Minack decided to come clean with his thoughts on this subject.
He is leaving Morgan Stanley and wanted to share his take on the investment industry. Here are some of his thoughts on individual investors:
“Amateurs normally stand no chance against professionals,” he writes, noting that most of us would be unlikely to play tennis better than Roger Federer or golf better than Tiger Woods.
“Investing is different,” he continued. “None of this would matter if achieving index returns was extremely difficult. But an industry’s been built on indexed funds that seem capable of replicating index returns at relatively low cost.”
He shared this graph which shows the average underperformance of active large-cap stock mutual funds since 2003:
So about 60% of active funds fail to beat the market return year in and year out.
Minack goes on to discuss how our investor behavior can cause the underperformance of these actively managed funds to be even worse than advertised:
“The good news for the professionals is that many amateurs persist in trying to beat the market and, in aggregate, they seem to do a significantly worse job than the professionals.
The biggest problem appears to be that – despite all the disclaimers – retail flows assume that past performance is a good guide to future outcomes. Consequently money tends to flow to investments that have done well, rather than investments that will do well. The net result is that the actual returns to investors fall well short not just of benchmark returns, but the returns generated by professional investors.”
So not only do actively managed funds fail to beat index funds over time, our behavior causes the actual results to be even worse.
In the book the Behavior Gap, this is call the difference between the investment return and the investor return. The two are not the same because of our affinity to make the wrong moves at the wrong times.
Here is graph he provided which shows some pretty scary numbers on just how badly investor behavior affects our investment results:
Business Insider tells us in the article that an investor who did a simple buy and hold strategy by investing $100 in 1997 in the Nasdaq would have ended up with about $150 today.
But the actual cash flow weighted returns show that investors traded at the absolute worst times with market movements and actually would have lost almost 75% of their money in this example. Ouch.
This has to do with buying when markets are up and selling when markets are down. Trading on instinct can obviously be detrimental to your investment performance.
I’m not placing all of the blame on investors in this case. Most people out there are uninformed about the financial markets and many assume that financial professionals are there to help them. Most are more interested in making money than actually helping clients.
Complex investments with large fees are much easier to sell than the simple, low-cost strategies. Most people mistake complex for intelligent. In the investment world it’s actually the opposite.
It’s boring to invest in a disciplined manner using simple index funds. Have you ever heard someone brag about rebalancing their index funds at a cocktail party? Of course not. But investors love to talk about the latest biotech stock that they bought or the next Apple that their broker just told them about.
Here’s one more quote from Minack on the finance industry and why investors will always keep people like him employed on Wall Street:
“In short, amateurs may be able to beat the investment professionals, but most do far worse. This keeps professional investors in business (and that keeps people like me employed, which is nice). But it means that returns to investors typically lag benchmark returns by a long margin. The outlook, in my view, is for low returns ahead, as measured by common benchmarks. If investors continue to receive materially worse returns than those benchmarks, effective returns are likely to be derisory.”
It’s refreshing to hear someone in the investment profession be so open and honest about the way things really work. It’s also sad because I think the majority of what he is saying is probably true going forward unless investors start taking control of their investment plans.
Do me a favor and try to prove Mr. Minack wrong about amateur investors.
That means stop trading every big piece of news you read about the economy. Don’t check your statement balance every single day. Align your actions with your long-term goals.
Set up a disciplined investment plan that matches your risk tolerance with your time horizon. Keep your costs low and try to minimize mistakes. Spend less than you earn and save for the future.
The rest is out of your control. Coming to this realization will save you a lot of stress about your finances.
Also, please read the article I wrote for Dividend Ninja about the affects of rising interest rates on bonds: What Happens to Bonds When Interest Rates Rise.
And here’s what I’ve been reading this week:
- In Complex World, Investing Should be Simple (CBS Moneywatch)
- Why Investors Fail (Motley Fool)
- Can Stocks and Bonds Both be Right? (Wall Street Journal)
- Dear Class of ’13: You’ve Been Scamed (MarketWatch)
- What is You Market Context? (The Big Picture)
- What Stock to Buy? Hey Mom Don’t Ask Me (NY Times)
- Why Entrepreneurs Should Not Buy Homes (Tech Crunch)
- Migrating from Facebook to Twitter (AP)
- The Portfolio Manager Strategy Cycle (Pragmatic Capitalism)
Interesting review of the truth. Actually a confirmation of what’s happening and well known. Unfortunately people do not know and in many cases refuse to admit. I was one of them who believed that active trading can bring a lot better results. Unfortunately it won’t.
On the other hand I do not like funds as well and think and believe that buying high quality dividend growing stocks will beat all funds, even the index ones.
Very true. Hard to belive that more people don’t understand this point.
Stay tuned as I have a post coming this week with some historical data on high quality dividend stocks that you should find interesting.