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Why Do Individual Investors Underperform?

Bonds, dividend investing, ETF investing, currencies “}); $$(‘#article_top_info .info_content div’)[0].insert({bottom: $(‘mover’)}); } $(‘article_top_info’).addClassName(test_version); } SeekingAlpha.Initializer.onDOMLoad(function(){ setEvents();}); Barry Ritholtz posted a good video discussing whether mutual fund managers are skilled or not. I am not going to discuss the points made in that video, however, it did get me thinking about something. I have found that most mutual funds are closet index funds. That is, the vast majority of mutual funds are not engaged in any sort of strategic asset allocation that differentiates them sufficiently from highly correlated index funds. So, your average XYZ Large Cap fund will tend to have a 85%+ correlation to the S&P 500, but it will charge a much higher fee. Over time this will degrade performance since the mutual fund is basically picking 100-200 stocks inside of a highly correlated 500 stock index and charging you a recurring high fee over time. Vangaurd has shown on multuple occasions that it’s fees, not asset picking skill, that drives underperformance. But what’s interesting about these mutual funds is that even though they can’t beat their index they do tend to beat the average individual investor. This has been well documented in research pieces ( such as this one ), but we also know it’s true thanks to investor surveys like the AAII asset allocation survey. Over the last 30 years AAII has maintained a record of individual investor asset allocations and over this period the average allocation has been: Stock/Stock Funds: 60% Bonds/Bond Funds: 16% Cash: 24% What stands out there is the cash position. Of course, “cash” is a bit of a misnomer in a brokerage account because “cash” is usually just T-Bills. The kicker is, cash (or short-term bonds) has been a big drag on performance over the last 30 years. The AAII investor with an average 24% cash position generated just a 8.4% annualized return relative to a 9.1% return for the average investor who invested that 24% in a bond aggregate (your standard 60/40). And keep in mind that this is before accounting for all the inefficiencies documented in the aforementioned research. The interesting point here is that most professional money managers don’t hold a lot of cash at all times. The latest data from ICI showed that the average equity fund had just 3.5% cash. Since bonds and stocks just about always beat cash over a 30 year period we know that the average individual investor with a 24% cash position MUST, by definition, do worse than even the closet indexing professionals. This doesn’t mean the closet indexers are “skilled”. It just means they benefit from being in the game more. Basically, you can’t score if you aren’t even on the field and while closet indexing mutual funds are worse at scoring than their benchmark, they score more often than individuals because the individuals spend too much time out of the game. So, the question is, why do individual investors tend to hold so much cash? I have a few guesses: Individuals are inherently short-term in their thinking because they know, intuitively, that their financial lives are a series of short-terms inside of a long-term. This short-term perspective is a totally rational reaction to uncertain financial markets. A high cash balance provides the ultimate sense of certainty. This is a silly perspective, however, because informed market participants know that financial asset market returns tend to become more predictable over longer periods of time. This does not mean, however, that we should necessarily apply the textbook idea of the “long-term” to our portfolios as this isn’t always consistent with our actual financial lives. This short-term thinking leads most investors to churn their accounts, pay high fees and pay high taxes. Again, it’s an attempt to create certainty in an inherently uncertain financial world. But the attempt to take control in the short-term generally results in lots of detrimental activity that hurts performance. I tend to be prefer a cyclical timeframe because it captures the best of both worlds – it can be tax and fee efficient without taking the irrational textbook “long-term” perspective. This raises a more interesting question. Can this behavior be fixed? I’m not so certain. In a world where we’re prone to thinking in the short-term the idea of “long-term” and even medium term investing is very difficult for most people to maintain. But what it does show is that more investors need to be aware of their behavioral biases and understand the basic arithmetic of asset allocation . You might not become a global macro asset allocation expert, but you can avoid making many of the short-term mistakes that lead to this disparity in performance. Sources: Share this article with a colleague

2 Hot Sector ETFs Soaring To Rank #1 This Summer

The U.S. stock market has started to feel the heat of summer in some corners. While the S&P 500 and the Dow Jones Industrial Average have seen a lazy summer lull so far, the Russell 2000 Index and Nasdaq Composite Index have been burning with impressive gains of 3.6% and 1.8%, respectively, over the past one month. Increased confidence in the U.S. economy as well as a slower-than-expected Fed rate hike path is boosting specific sector stocks. In particular, financials are soaring on a rising rate environment while technology and health care have been the investors’ darlings when it comes to defensive trading. These sectors are likely to witness strong growth for the rest of summer. In fact, the spread out exposure to all market caps or a definite tilt toward small caps might lead to outsized gains. Additionally, U.S.-focused sectors offer investors with protection from the worst of the global turmoil, especially the looming Grexit fears. That being said, there are number of choices in these sectors but looking at the Zacks ETF Rank could help us to pick the likely best. The system looks to take into account a variety of factors, such as industry outlook and expert surveys; and then apply ETF-specific factors (like expense ratios and bid/ask spreads) in order to find the best funds in each segment. Using this system, we have found a handful of ETFs in the hot sectors that have earned themselves a Zacks ETF Rank #1 (Strong Buy) in the latest ratings update, and could thus outperform. In fact, a couple of funds in their respective sectors have seen their Ranks surging to the top hierarchy from #3 (Hold) and could make great summer picks. iShares U.S. Broker-Dealers ETF (NYSEARCA: IAI ) With the prospect of rising rates later in the year albeit at a slower pace, financials will remain on investors’ hot list for the coming months. This is because rising rates would boost income for banks, insurance companies and discount brokerage firms. Additionally, the more volatile but improving market bodes well for exchanges like ICE (NYSE: ICE ), NYSE or CME (NASDAQ: CME ) and those with large investment portfolios. Given this, the broker-dealers corner of the financial segment looks brighter and one way to tap the bullish trend is with IAI. This fund offers exposure to the U.S. investment banks, discount brokerages, and stock exchange firms by tracking the Dow Jones U.S. Select Investment Services Index. The product currently holds 25 securities with double-digit allocation going to Goldman Sachs (NYSE: GS ) and Morgan Stanley (NYSE: MS ). Other firms hold no more than 8.3% of assets. The ETF has a nice mix of all cap securities with 49% going to large caps, 32% to small caps, and the rest to mid caps. It has a certain tilt toward value securities, which tend to be less volatile and offer nice price appreciation opportunities. The fund has accumulated $354.2 million in AUM while sees good volume of nearly 76,000 shares a day. The product charges 43 bps in fees per year from investors and gained 2.2% over the past one month. PowerShares S&P SmallCap Health Care Portfolio ETF (NASDAQ: PSCH ) This ETF has been the clear winner in the broad health care world, returning nearly 23.5% so far this year and up 4.7% over the past one month. This is primarily thanks to strong earnings, merger frenzy, aging population and the Affordable Care Act or Obamacare. The sector’s non-cyclical nature is an advantage in the current environment, where concerns are spiking on global growth, stretched valuations, Greece crisis and uncertainty regarding rate hike. Apart from these, the concentrated exposure to the small cap health care securities is benefiting PSCH given the gradually improving economy. The fund tracks the S&P Small Cap 600 Capped Health Care Index and holds 72 securities in its basket with each holding less than 4.4% share. From an industry look, about one-third of the portfolio is allotted toward health care equipment and supplies followed by health care providers and services (29.2%) and pharmaceuticals (12.6%). The ETF is unpopular, having amassed $233.8 million in asset base and trading in lower volume of about 19,000 shares per day, while charging a relatively low fee of 29 bps a year. Bottom Line These sector ETFs have been the leaders to start summer and look protected from the global turmoil. Given that this trend will continue for the rest of the season, investors should definitely look at these ETFs or the other funds in the sector that have recently seen their Zacks Rank surging to #1. Originally published on Zacks.com

Predicting The Future Is Difficult

Neils Bohr, a Nobel prize-winning Danish physicist who made foundational contributions to the understanding of atomic structure and quantum theory, is credited to have once said: “Prediction is very difficult, especially if it’s about the future.” While it sounds more like a ” Yogi-ism ,” the point made is interesting particularly as it relates to investing. I was reminded of this quote by a comment made on a recent post entitled “Bullish Or Bearish, What The Charts Say.” As I stated in that post: “I really don’t care much for the “bull/bear” debate that ensues on a daily basis as both camps are eventually wrong. When investing in the markets ‘it is, what it is’ and it is of very little use that some pundit or analyst was ‘right’ during the bull market if they never saw the bear market coming. The opposite is also true.” Predictions of the future are indeed very difficult, and yet individuals are challenged every day with doing precisely that. For traders, it is what the market, or a particular investment, will do in the next few minutes to days. For longer-term investors, those predictions move out to months or years. The problem is that humans generally suck at predicting the future, particularly when it comes to investing. This is clearly shown in Dalbar’s 2015 investor study in what they term the ” Guess Right Ratio .” To wit: “DALBAR continues to analyze the investor’s market timing successes and failures through their purchases and sales. This form of analysis, known as the Guess Right Ratio , examines fund inflows and outflows to determine how often investors correctly anticipate the direction of the market. Investors guess right when a net inflow is followed by a market gain, or a net outflow is followed by a decline. Unfortunately for the average mutual fund investor, they gained nothing from their prognostications. ” (click to enlarge) The inability of investors to correctly predict the future has had serious consequences for their portfolio both in the short and long term as shown by the two tables below. (click to enlarge) (click to enlarge) The massive underperformance over a 30-year span shows that investors, despite the best of intentions of being ” long term ” are saddled not only by poor predictions of the future, but also the ” emotional biases ” that drive accumulations and liquidations at the most inopportune times more commonly known as the “buy high/sell low” syndrome. Currently, it is ” predicted ” that the market will only rise from current levels as witnessed by a recent report from Brian Wesbury at First Trust: “Using a 4% 10-year discount rate gives us a ‘fair value’ calculation of 2,550 and it would take a 10-year yield north of 4.8% and no growth in corporate profits in Q2 for the model to suggest equities are fully valued.. .investors should be more tilted toward equities than they would normally be and we believe those that are should continue to enjoy attractive returns over at least the next couple of years. This bull has further to run .” However, Brian, like all humans, including me, are horrible predictors of future outcomes. As an example, this is what Brian predicted in July 2007 just before the largest financial crash since the ” Great Depression :” “The bottom line is that fears about the underlying health of the economy and financial markets are more about hypochondria than reality. The Fed is not tight, just less loose, the economy is strong, tax rates are low, and corporate earnings remain robust. Let’s not confuse indigestion and heartburn with the ‘big one. ‘” Or this in February of 2008 as the recession was in full swing: “None of this is an attempt to say that a recession is impossible. Recessions are always possible. But neither the policy pre-conditions, nor the data, suggest we are anywhere near a recession today. Current fears of a recession are premature .” Of course, it did turn out to be the “big one.” However, Brian, like all economists and analysts are using data to make future predictions that are highly subject to revisions in the future. This is the equivalent of trying to shoot a moving target while blindfolded riding a merry-go-round. While I am sure there is some trick shot artist that could nail such a feat on “America’s Got Talent,” for the mere mortal the odds of success are extremely low. The same problem that exists for individuals, also applies to ” professionals .” There are but a handful of investment managers that have consistently outperformed the ” market ” over long periods of time. But even that comment is a bit misleading as relative outperformance is of little consolation to investors when the market is down 30%, and the portfolio is down 29%. Did the manager outperform? Yes. Did the investor stick around? Probably not. But it is precisely this conversation that leads to a litany of articles promoting ” buy and hold ” investing. While ” buy and hold ” investing will indeed work over extremely long periods, investor success is primarily a function of time frames and valuation at the beginning of the period. Considering that most investors have about a 20-year time horizon until they reach retirement, the “when” becomes a critical component of future success. (click to enlarge) Of course, ” buy and hold ” commentary is mostly seen near fully mature “bull markets” as the previous bear market fades into distant memory. Eventually, despite the best of intentions, the markets will complete their full-market cycle and investors will head for the exits perpetuating the ” buy high/sell low ” syndrome. It is here that we find the VERY BEST predictor of future outcomes – past behavior. Psychology Today had a very interesting piece on this particular issue as it relates to violent crimes. But when it comes to investing, most individuals fit the requirements necessary to fulfill how they will behave in the future. Habitual behavior – (buy high/sell low) Short time intervals – (months or years, not decades) Anticipated situation aligns with the past situation that activated behavior. (bull vs. bear market) Behavior not extinguished by negative impact. (loss not great enough to deter future action) Person remains essentially unchanged. (speculator vs. saver) Person is fairly consistent (willingness to accept risk/avoid loss) Certainly, past behavior may not accurately predict the future behavior of a single individual. However, when it comes to the financial markets which is representative of the ” herd mentality ,” past behaviors are likely good indicators of future outcomes. Despite an ongoing litany of bullishly biased reports as markets push towards new highs, it should be remembered that markets only attain new highs about 5% of the time historically speaking. The other 95% of the time is recouping previous losses. (click to enlarge) Does this mean that you should sell everything and go to “cash?” Of course not. However, it does mean that as an investor you should critically analyze your past personal behavior during market advances AND declines. If you are like MOST investors , it is likely that you did exactly the opposite of what you should have. If that is the case, does it not make some sense to begin thinking about doing something different?