Some things never change. What is the one thing we should have learned from the market crash in 2007-2009? Hopefully, it's that staying the course pays off. Those that can tolerate some pain will be handsomely rewarded for their patience. The only people that really got hurt in 2008 were the ones that sold. Following the crash, the markets recovered all their losses and then went on to make new highs. So with that fresh in our minds, what were investors doing during this correction? You guessed it (via Merrill Lynch):
Not only were daily outflows their highest level since 2007, but a collective $29.5 billion were pulled from equity funds for the week. This is the worst level since they began collecting this data (which goes back to 2002). Not surprisingly,8/25 marked the height of outflows this week and the S&P 500 is now up over 6% from that day. Successful investing goes against every instinct we were hardwired with from our ancestors. Our fight or flight response kicks in when we see losses in our portfolio and our brain tells us we have to do something. The best investors are those that can bury these instincts and think about their portfolio in terms of decades, not days.
There is a funny scene in the movie Forgetting Sarah Marshall when the lead actor is trying to learn how to surf. His instructor continues to tell him, "do less" to the point where he becomes exasperated and just lays on the board not knowing how to follow his instructions.
If we are honest with ourselves this is probably similar to how the average investor has felt over the past couple weeks. Doing less seems idiotic at times. Everything we watch on TV or read seems to make us think we should be making changes to our portfolio. The market is crashing, don't just stand there, do something! The reality is that over time the less we do the higher the probability we have for a successful outcome.
Doing "something" usually involves trading. This is either to try to time the market or move into a different type of asset class. There are two problems with this. First, you probably can't do it consistently. Think about it this way, no matter what you are trying to do, there is going to be someone else on the other end of your trade. The competitiveness and brilliance in the market is astonishing today so if you think you will be able to consistently beat other market participants, you may be a tad overconfident. Second, when you trade more often you are creating taxes and fees which ultimately will erode your portfolio.
The only caveat to this is that it is normally a good idea to rebalance your holdings if the portfolio has significantly strayed from your desired allocation. As hard as it is, and as silly as we may feel, you should fight your instincts and "do less" with your portfolio. Your long-term wealth will be better off.
Diversification is the only free lunch when it comes to investing. I think investors nod their heads when they hear this phrase but most don't truly believe it. Do you? If you agree with this, have you bought any individual stocks in the past? If so, I ask you again, do you believe in diversification because your actions don't match your beliefs?
There are some fascinating numbers coming out about winners and losers in the market this year. Take a look at this chart from the Irrelevant Investor blog:
The Russell 3000 is comprised of approximately 98% of the publicly traded stocks in the US market. While the average stock is down over 20% from its all-time high, the Russell 3000 is only down 2.9% from its all-time high. How is this possible? There is a small group of stocks that are keeping this market afloat. This is not very different from history either. According to the blog, since 1926:
- The average return of all stocks is 9.9%
- Excluding the top 10% of performers, the market return falls to 6.5%
- Excluding the top 25% of performers, the market return is negative at -0.3%
This shows us how important diversification is. Market returns are historically driven by a small number of high flying stocks. Sure you could pick one of those stocks in advance and really have outsized returns, but the odds are against you. It is much better to diversify. Smooth out your returns and accept what the total market will give you by owning the entire market.
I've been thinking about how detrimental the financial news media can be to investors. I can't tell you how many times I've had conversations with clients about things they read in the media that have no bearing on their long-term financial plan. What do you think is going to happen in Greece, I'm concerned what rising interest rates could do to my emerging markets stocks, how do you think China's slowdown will impact oil prices? These are just some of the questions I've received from clients after reading an article on Yahoo or the Wall Street Journal. But be honest with yourself…if the media told the truth, would you read it? Here is what the article headlines would look like if they told the truth:
- A bunch of stuff happened today that has nothing to do with your long-term future. Stick with your plan
- Remain diversified.
- Remember to keep costs low in your portfolio
- Don't pay attention to the day-to-day noise happening in the world. Remained disciplined in your investment plan
- Don't trade very often
If those aren't the most boring news headlines, I'm not sure what are. But they are all truths that people should be following. If the financial media actually told the truth you would do one of two things:
- You'd get bored and stop reading those articles
- You'd get their point and stop reading those articles
In both cases, you stop reading their articles which is bad business for them. Remember, the media generates their revenue from readership and eyeballs. The only way to keep people reading is to continue to publish spectuacular stories. Journalists are not here to advise you. Please make sure you remember this the next time you are thinking about making a change to your portfolio after reading a story about the markets or the economy.
When you read or listen to investment analysts, you will often hear that certain periods are "stock pickers markets". The argument is that when the market is flat or declining you want a manager that can navigate the landscape, stay on the sidelines, or get more defensive when necessary. I always get a chuckle when I read these articles. The Wall Street Journal has an entire article talking to experts about when active management makes sense. The answer to this question could be answered by a student in middle school with basic math skills. Active investment management will always underperform their passive counterparts.
Nobel Prize winner Bill Sharpe, in his paper "The Arithmetic of Active Management" wrote the following:
Properly measured, the average actively managed dollar must underperform the average passively managed dollar, net of costs. Empirical analyses that appear to refute this principal are guilty of improper measurement.
Let me try to put it more simply. If we assume that the entire market consists of all the active and passive managers, then trading is a zero sum game. If I buy GE in my portfolio and it goes up (making me the winner), some other manager had to have sold me that stock (making them the loser). The totality of all the money managers will be the same return of the market BEFORE FEES. And there's the catch. Active managers charge higher fees than their passive counterpart, meaning that over ANY time period, active managers, as a whole, will underperform passive managers by the amount of their fees. Again, the math tells us this is true over any time period: 1 day, 1 year or 20 years.
Now, what I am not saying is that ALL active managers will underperform. I am just making the true statement that the average of all active managers will have to underperform. Random chance tells us that some will outperform and some will underperform. I'll leave the question of whether you can know who will outperform in advance to another post.
Information contained herein has been obtained from sources considered reliable, but its accuracy and completeness are not guaranteed. It is not intended as the primary basis for financial planning or investment decisions and should not be construed as advice meeting the particular investment needs of any investor. This material has been prepared for information purposes only and is not a solicitation or an offer to buy any security or instrument or to participate in any trading strategy. Past performance is no guarantee of future results.