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Summary Investors overestimate their knowledge of financial markets. Realized returns of individual investors substantially lag benchmark results. There is no clear evidence of persistence in mutual fund returns. Most investors have some kind of view on today’s stock and bond markets. It’s only natural. Financial media is everywhere. Investment news and opinions are delivered to our smartphones as soon as they are written. While the bandwidth of financial information has expanded dramatically, its noise to signal ratio remains stubbornly high. Buy Gold! Metals are dead! The Stock Market is too high! The Market has room to run up! The reality is that almost no one knows. And it’s virtually impossible for John Q Public to identify those few who do know. This newsletter talks about investor convictions and their impact on financial outcomes. The Big Picture One way to evaluate the success of individual investor sentiment is to take a look at aggregated performance. How is everybody doing? As a group … very poorly. DALBAR is an independent consultancy that reports annually on the success that individual investors enjoy relative to various financial benchmarks. In effect, they measure the ability of the public to time movements into and out of mutual funds over long periods of time. There is a lag between expectations and performance. For the 30 years ending 2014, average equity and bond fund investors massively underperformed their respective benchmarks – the S&P 500 and Aggregate Bond Index. Why is the Investor so Wrong? There are two basic explanations for the lag. Investors repeatedly demonstrate tendencies injurious to financial health. Collectively, they lurch from euphoria to panic – based on recent market performance. In fact, investor performance lags are largest during periods of heightened market volatility. These general conclusions deserve some anecdotes. Gallup and Wells Fargo conduct a quarterly survey on investor sentiment by interviewing over 1000 individuals with stock market exposure. They distill the responses into an index of overall market optimism. It reached its apex in January 2000 – 2 months before the dotcom bust. The sentiment index reached its nadir in February 2009 – one month before what has become the 3rd longest bull market in American history. So much for investor convictions. It has been my experience that investors overestimate their own ability to maintain rationality in the face of market turbulence. The aggregated date supports this view. According to a Wells Fargo/Gallup survey conducted in early February, 76% said they were either very or somewhat likely to take no action during market volatility. Yet investors exited the equity markets en masse in late 2008. The second problem with investment outcomes are the products themselves. The mutual funds that investors choose to implement their beleaguered strategies also fall short of the mark. Fund companies spend fortunes to convince the public that their portfolio managers can beat the market through astute security selection or tactical asset allocation. These superstars get paid well. Data compiled by Morningstar indicates that the cost structure of mutual funds has remained high in the new century. The average US equity mutual fund still charges 1.25% annually. Given the secular decline in bond yields, this resilience of high fees is especially surprising in the fixed income space. Fees in the average bond fund now exceed 25% of the yield to maturity of the ten year Treasury bond – up from 13% a decade ago. Have the expert fund managers delivered? The aggregate data tells us no. In fact, actively managed mutual funds lag the performance of a corresponding index by an amount that is not significantly different than the expenses they charge. A reasonable response to this result might be that mutual funds cannot beat the average because they are ultimately competing against themselves. It’s up to individual investors or their investment consultants to identify the “best of breed” managers in each asset class. A foundational approach in this effort is the evaluation of past performance. Again the data throws cold water on this theory. Past performance demonstrates virtually no persistence across a wide range of equity mutual fund asset classes. Top quartile performers depart the top quartile at the rate faster than predicted by random chance. If returns were completely random from year to year, there would be a 25% likelihood that a dart throwing manager could return to the top quartile. Doesn’t work that way as selected data from S&P Dow Jones indicate in the table below. Is There a Better Way? There is a corollary to the rather pessimistic findings of the previous section. If moving assets around is a destructive behavior, then keeping them in place is a better option. Long term performance of the major classes has been sufficient over the last ten or even hundred years to deliver comfortable retirement outcomes to most serious investors. Sure, it’s no guarantee that the public financial markets will continue to serve as stores of value. But stocks and bonds are about the best option the investing public has. A qualified investment advisor can play a constructive role here. Besides the technical ability to craft and implement an investment plan, a key advantage is the discipline that investors gain to stick to the plan amidst the financial noise that is sure to follow. Vanguard estimates that behavioral coaching is worth about 1.5% to investors each year. Based on a Vanguard study of actual client behavior, we found that investors who deviated from their initial retirement fund investment trailed the target-date fund benchmark by 1.5%. This suggests that the discipline and guidance that an advisor might provide through behavioral coaching could be the largest potential value-add of the tools available to advisors. Although the financial markets have suffered few reverses over the past six years, rest assured that market panics will follow at some point. Consider the wisdom of Meir Statman, Professor of Finance at Santa Clara, who wrote the following in the Wall Street Journal near the nadir of the recent financial crisis when investor sentiment was stacked against the stock market. Don’t chase last year’s investment winners. Your ability to predict next year’s investment winner is no better than your ability to predict next week’s lottery winner. A diversified portfolio of many investments might make you a loser during a year or even a decade, but a concentrated portfolio of few investments might ruin you forever. Consistency will get you there. Have the courage NOT to act on your own beliefs. It will be worth it. 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