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The Myth of Beating the Market

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Americans have been talking a lot about the “fake news” phenomenon, but fake news has been part of the investment world for some time—on TV, online and at cocktail parties. How many “hot stocks” and “can’t-fail strategies” have you heard about over the years? How many clients and prospects have ambushed you with a stock guru’s newsletter? Who hasn’t wished they could be the next Peter Lynch, Bill Miller or Bill Gross? 

As the business and service model for financial advisors continues to evolve—with or without the DOL’s fiduciary rule—advisors have been deluged with messages about abandoning the promise of performance. Many of us learned in 2008, quite painfully, that clients who came to you for performance will abandon you when you can’t provide it.

What’s more, with the rise of automated investment providers, clients who come to you for asset management alone may drop you for a robo if they decide that a human money manager is too expensive.

What do you have to offer that’s distinctive—and that is more likely to help you “win” over the market than picking outperforming stocks? As an advisor, you can influence your clients to improve their savings habits, take appropriate risks (and avoid inappropriate ones), manage their tax exposure and stick with a disciplined, cost-effective strategy that will help them achieve their goals.

Easy peasy, right? Well, actually, not so much.

A great source for examining investor behavior is Dalbar, the independent research firm that has been studying investment performance and investor behavior since 1976. Over the years, Dalbar provides evidence that investors typically behave in ways that run counter to their best interests.

The result, of course, is impeded investment performance. Dalbar’s most recent survey, its 22nd Annual Quantitative Analysis of Investor Behavior (2016) found that for the 20-year period ending on December 31, 2015, the average equity mutual fund investor’s annualized return was a mere 4.67%, far less than the performance of the market over all.

In contrast, the Standard & Poor’s 500 Index, often used as a benchmark for the whole stock market, produced a 20-year annualized return of 8.19%. That’s a difference of 3.52 percentage points, a huge disparity, especially over a 20-year period.

Of course, some of this difference in returns may have to do with diversification. But we’re talking equities here, folks, and the various elements of the equity market have become more tightly correlated over the years, not less.

It’s worth keeping in mind that some behavioral finance studies have found that advisor behavior is quite similar to that of investors’.

A 2012 paper published by the National Bureau of Economic Research, for instance, found that, like investors, advisors frequently chase performance rather than creating a disciplined asset allocation. The NBER study suggested that “the market for financial advice does not serve to debias clients but in fact exaggerates biases that are in the adviser’s financial interest while leaning against those that do not generate fees,” wrote authors Sendhil Mullainathan of Harvard, Markus Noethof the University of Hamburg and Antoinette Shoar of MIT.

Even so, the paper’s authors acknowledged that advisors have value beyond investment selection, “for example, by giving them the confidence and information to invest in risky assets in the first place, by protecting them from losing money in fraudulent funds, or by reducing transaction costs. These reasons might be as important as the actual content of the advice,” the researchers wrote.

One area where advisors shone was encouraging people to reduce their concentrations of company stock. Another area was discovery—advisors were adept at eliciting information about client demographics, sources of income, additional investments and financial goals. But they were likely to push active over passive management and to gloss over their costs, and more likely to recommend well-diversified portfolios to married, high-income couples and men.

Single women and less-affluent couples tended to be recommended portfolios with higher allocations to cash and lower allocations to international investments.

The DALBAR study, in contrast, compared investors who went solo with those who consulted financial advisors. Here’s what the researchers found: 

  • Investors lack patience and try to time the market. Rather than “buy and hold,” they follow a “buy and fold” strategy, exiting a fund, stock or bond when they think they can find better returns in a different fund, stock or bond. The average investor switches out of investments after about four years. That is short-term thinking. And it doesn’t pay off.
  • When it comes to buying low and selling high, investors have historically failed. They simply can’t help it. From a behavioral point of view, people are “loss averse.” During the past two major market downturns, 2000-2003 and 2007-2009, investment in money market funds (considered a safer harbor) soared. This is not just a problem for the DIY crowd. How many advisors have boasted that they got their clients out of the market as it crashed? But this habit of selling during market drops has historically resulted in significantly lower returns for the simple reason that investors tend to be slow to reinvest.  They hang on to the cash they got when they sold at a loss, and only think it’s “safe” to get back into the market when prices are high again. To the contrary, the greatest profits are to be made when markets begin to recover—and it’s hard to pinpoint that moment.
  • A diversified portfolio tends to mitigate risk and stabilize returns, but not during market meltdowns, when asset prices become highly correlated. This discourages investors—and even some advisors—from maintaining a diversified portfolio.

What the Dalbar study makes clear is that investors can be their worst enemies if advisors let them give in to their instincts rather than taking a disciplined approach to investing. The problem is that advisors, being human, often act on the same instincts—and education only goes so far in preventing destructive behavior. 

The remedy? Just let go of the myth and cleave to a disciplined approach to investing.

Yes, this is not a new idea, but it’s one that bears repeating when research shows that all of us, no matter how professional, have trouble sticking with the program.

Rather than trying to beat the market, we all should continually re-commit to a disciplined investment approach, protecting clients from hasty decisions, urging them to save as much as possible, and helping to keep advice and investment fees at a reasonable level. 


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