The whole premise of a typical market “buy and hold” strategy presumes you have the intestinal fortitude to ride out long bear markets. The average investor actually gets much less in the market because people are motivated more by emotions than logic with markets. So they get out after long downturns and get back in after rallies have been in place for a while. This isn’t just opinion; Dalbar, a risk-management company out of Boston, has been publishing its “Quantitative Analysis of Investor Behavior” since the mid-nineties. In its 2016 report it states:
“In 2015, the average equity mutual fund investor underperformed the S&P 500 by a margin of 3.66%. While the broader market made incremental gains of 1.38%, the average equity investor suffered a more-than-incremental loss of -2.28%… In 2015, the 20-year annualized S&P return was 8.19% while the 20-year annualized return for the average equity mutual fund investor was only 4.67%, a gap of 3.52%.”
So this is an actual thing. How much does a 3.52% gap mean over a 20 year period? If you put $100,000 in the S&P 500 and were able to gut it out over the past 20 years, and assuming a .5% index fund fee, you would have had $440,000. The average investor would have had $249,140, a difference of $190,919.
What accounts for the difference? Well, certainly management fees are part of it. But the bigger part is we are just plain crazy. But it’s not our fault. We are wired this way from the very first humans huddling in the dark and cold. When we sense danger, we flee. When we sense opportunity we strike. It’s called survival.
And while it worked pretty well for the cavemen, it’s not so good for investors. We fight our emotions and our nature all the time in the market. In the market, unless you are supremely disciplined, we are all bipolar. As markets crash, we tend to hold on until we can’t hold on anymore and then we run, usually selling at near the low. Then we resist buying back in until we can’t stand it anymore, often buying in at or near the high. We can’t help ourselves. It’s who we are.
There are some really effective things we can do about this, however. The first thing is to find our comfort zone. If we can limit the ups and downs to a range we can comfortably live with, we won’t find ourselves being quite as crazy. A really easy way to do this is using a risk number assessment tool. There are a few of them. My favorite is Riskalyze. You can find it at FreeMoneyGuys.com. Once we determine your risk number, it is then possible to load your portfolio and determine if they match. If not we adjust the portfolio since we cannot change human nature.
The next thing you can do is replace your emotions with a formulaic approach to investing. There are two basic schools on investing. The first, “buy and hold” (buy and hope?), is based on Modern Portfolio Theory (MPT), first floated by Harry Markowitz in the 1950s. MPT states it’s possible to chart various portfolios along with an “Efficient Frontier” (EF) of return (Y-axis) and risk as measured by standard deviation (X-axis). Once you have identified where each portfolio falls on the EF, you can determine which level of risk and reward is best for you, then you invest at that level and hold it for the duration. It’s interesting that the number-one way people generally buy and hold is index funds, usually tied to the S&P 500, which it turns out, is extremely inefficient, carrying way too much risk for the reward it yields. Mutual funds are the primary tools of this type of investing.
On the other side of the fence is the “tactical” approach to investing. Tactical investing supports the idea it IS possible to beat the market by following various indicators which in turn trigger buy and sell signals. Using Exchange Traded Funds (ETFs), which resemble mutual funds but are typically not managed and are bought and sold on exchanges through brokerage accounts, tactical investing uses formulas to determine when to enter and exit the market. The goal of tactical is to capture about 70% of market upside and eliminate 60% of the downside. Done well, it can have a tremendous impact on one’s investments. It can also help people sleep better at night, knowing when a meltdown like 2008 happens we are safely sitting out the crash rather than participating in it.
Finally, you can help yourself by making sure your investments are not your primary source of income. It’s hard enough to deal with volatile markets when you have an independent source of income, let alone when you rely on your investments to live. We recommend, along with good investment strategies, a robust and safe income plan you know you can count on. That’s where good Social Security, pension, and annuity planning comes in.
Follow these three principles and you should not only do much better in the market, but you’ll do much better sleeping at night as well.