FORECASTS & TRENDS E-LETTER
by Gary D. Halbert
May 5, 2015
IN THIS ISSUE:
- Dalbar Studies – Why Investors Make Less than the Market
- Most Investors Are Not Good at Managing Money
- The Benefits of Professional Active Management
- Niemann Capital Management Has Beaten Market With Less Risk
Dalbar Studies – Why Investors Make Less than the Market
Long-time clients and readers will recall that for years I have been writing about the annual Dalbar Studies which compare the actual performance of mutual funds versus what the average mutual fund investor actually earns. You may also recall that the numbers are quite ugly – the average investor makes significantly less than mutual fund performance reports would suggest in both stock and bond funds.
[drizzle]The problem is not that mutual funds overstate their performance. The problem is that too many investors decide to switch into and out of mutual funds too frequently, in the hopes of boosting their returns. All too often, investors decide to sell the fund(s) they currently own, often at a low point, and switch into the latest hot performers, just before they hit a losing period. This practice too often results in selling low and buying high. I call it the “Mutual Fund Merry Go-Round.”
Dalbar tracks the actual returns earned by investors by analyzing mutual fund purchases and redemptions throughout the year. So, let’s look at the Dalbar numbers for 2014 and for the last 20 years on average:
In summary, the average equity investor underperformed the S&P 500 by a gap of 8.19% in 2014 and an average annual deficit of 4.66% over the last 20 years. The average fixed-income (bond) investor underperformed the Barclays Aggregate Bond Index by 4.81% in 2014 and an average annual deficit of 5.40% over the last 20 years.
If you have not seen these Dalbar statistics before, you are probably shocked. So was I when I first saw them in 1994! What is most surprising is that there has been very little improvement in the numbers over the last 20 years.
Most Investors Are Not Good at Managing Money
After decades of analyzing investor behavior in good times and bad, and after enormous efforts by industry experts to educate millions of investors, bad decisions continue to be widespread. When discussing investor behavior, it is helpful to first understand the thoughts and actions that lead to poor decision-making.
Investor behavior is not simply buying and selling at the wrong times; it is the psychological traps, triggers and misconceptions that cause investors to act irrationally. It is that irrationality which leads to the buying and selling at the wrong times, which leads to underperformance. Put differently, many investors are their own worst enemy when it comes to investing.
As a result of these findings from Dalbar and other market research groups, there is a widespread belief, not only among most investors but also among many industry professionals, that it is nearly impossible to beat the market. But that is simply not true, as I will demonstrate below.
While many retail investors, and even many professional investors, are not very good at making investment decisions, there are some Registered Investment Advisors (RIAs) and other professionals that have been successfully investing in the markets for years.
Most successful RIAs (and other successful traders) use proprietary software that they have developed internally. Some use complicated algorithms that determine whether to be in the markets, or on the sidelines in the safety of cash. Many rely on multiple indicators within one strategy.
Most of these actively-managed systems are designed to be in the markets (long) most of the time. However, at certain points, based on various risk measurements, the system may signal that risks outweigh any possible return potential. Systems vary widely of course and some may move only partially to cash, while others may be 100% in cash until market conditions improve.
The Benefits of Professional Active Management
Before I begin this section, let me state for the record that many active management systems, including some that are managed by professionals, don’t work. Since we founded Halbert Wealth Management (HWM) in 1995, we have looked at hundreds and hundreds of active managers, and I would venture that over 90% either weren’t successful or didn’t meet our rigorous standards.
However, there are some very successful active managers in the industry. Unfortunately, most investors don’t know how to find them. Fortunately, at HWM we know how to find and evaluate them, and we have the resources to continually look for them all across the country.
With that said, let’s move on to the benefits of active management. The first goal of any actively-managed strategy is to reduce risk. Moving partially or fully out of the market may allow one to miss some of the large downward movements and bear markets.
I have reprinted this table many times over the years. It illustrates very clearly why it is so important to avoid big losses in the markets.
If you lose 20%, you must make 25% just to get back to breakeven. Lose 30% and you must make almost 43% to recover to even. Lose 40% and you have to make over 66% just to get back to breakeven. Lose 50%, as the S&P 500 did from late 2007 to early 2009, and you must make 100% to get back to breakeven.
As we all know, it took six years for the S&P 500 to recover to where it was when the financial crisis hit in late 2007!
The main problem with the traditional “buy-and-hold” strategy is that it subjects investors to very large losses from time to time. Sharp downward “corrections” occur fairly frequently, and we experience a serious bear market now and then. Most investors believe when they start out that they can be patient and hold on through these sometimes terrifying downturns.
Yet millions of investors panicked in 2008 and early 2009 and bailed out of the market, in many cases with huge losses. Most retirement accounts were devastated. As noted above, the S&P 500 Index plunged by more than 50% from late 2007 to the bottom in March 2009. Many investors vowed to never again put their money in stocks and have never gotten back in.
Sadly, they missed the historic bull market that has unfolded since then.
Again, the primary goal of a successful active management strategy is to avoid some of those losses