December 20, 2018
Written By: Andrew Hallam
Last week, I had dinner with a friend who I’ll call Tim. He retired when he was sixty. Now he’s seventy-two. While we ate, Tim gave me his personal investing story. He was a great saver, and he was always on the lookout for stock market forecasts.
In 2001, Tim read a prediction that stocks were going to crash. He sold everything, avoiding the market meltdown from 2001-2002. That was like walking into a casino for the very first time and coming out a winner. He didn’t know it then, but his luck spelled trouble for the many years ahead.
He moved back into stocks after the market had recovered. But those market-crash forecasts just kept coming. He traded in and out, based on “expert” predictions that were far more wrong than right. After we ate dinner, Tim showed me his portfolio. According to Schwab, it gained a compound annual return of 1.85 percent from January 2009 to November 30, 2018. Over this ten-year period, the rising price of a box of Kleenex beat his portfolio. He didn’t beat inflation.
Those that stayed invested, instead, made bucket loads of money. U.S. stocks averaged a compound annual return of 14.36 percent. A globally diversified portfolio of low-cost index funds averaged a compound annual return of 8.78 percent.
Growth of $500,000
January 2009 – November 30, 2018
|Portfolio Allocation||Compound Annual Return||End Value|
|100% U.S. Stocks||14.36%||$1,892,104|
|35% U.S. Stock Index|
25% International Stock Index
40% U.S. Bond Index
Tim’s portfolio is worth about $500,000. But if he had ignored all market forecasts (including the lucky one in 2001) he would have a lot more money now.
Unfortunately, Tim’s tale is common. Every year, Dalbar publishes its Quantitative Analysis of Investment Behavior. The firm looks at how stocks perform, compared to how the average investor performs. For example, the S&P 500 averaged a compound annual return of 10.16 percent over the 30-year period from 1987-2017. But according to Dalbar, the average investor in U.S. stocks, over this same time period, earned a compound annual return of just 3.98 percent.
Some people say Dalbar’s math is wrong. But nobody denies that a huge gap exists. Each year, Morningstar publishes Mind The Gap. The mutual fund rating company shows that investors routinely underperform the market and the funds they own. Sometimes, such differences are huge. For example, during the ten-year period ending December 31, 2013, Morningstar says the typical investor in U.S. stock market funds averaged a compound annual return of 4.8 percent. That would have turned $10,000 into $15,981.
Over that same time period, the typical U.S. stock (as measured by Vanguard’s Total Stock Market Index) averaged a compound annual return of 7.99 percent. That would have turned $10,000 into $21,578.
We can blame investment fees for a part of investors’ poor performance. But fear and greed are far bigger culprits. Over time, the opportunity cost would continue to grow as compound interest stretched it further. For example, assume one investor turned $10,000 into $15,981 over a ten-year period. A second investor turned $10,000 into $21,578. It seems like the behavioral mistake cost the first investor $5,597. But the long-term cost would be much more than that.
Assume the first investor recognized their mistake. They swear on Elvis’ grave never to speculate again. That’s good news. But, as shown in the table below, the long-term cost of their earlier mistake would continue to cost them money.
Behavioral Mistakes Over One-Time Period Will Continue To Haunt Investors
|Initial Value After The First Ten Years||Followed by Identical 40-Year Compound Annual Returns||End Value After 40 Years|
Investors perform poorly for two reasons. Many jump from fund to fund. They often sell funds that aren’t performing. They then jump into funds that have recently done well. But the funds they sold often grow…after they have sold them. And the funds they buy often lag…after they have bought them. As a result, plenty of people buy high and sell low.
Others listen to forecasts, much like my friend Tim. They jump out of stocks after an “expert” says they should. They jump back in, often after stocks have risen.
The past 10 years have been kind to U.S. stocks. Many new investors haven’t yet seen markets fall. Many old investors have fading memories of the circus that comes with every market crash. When stocks fall, the media interviews “experts” with world-ending forecasts. Plenty will say, “Stocks will keep falling. It’s going to be worse than 1929.” Others will say, “The market crash of 2008/2009 was nothing compared to what’s coming next.” You’ll see headlines that scream, “Save Your Money By Jumping Into Gold!”
Another stock market crash is coming. Over my lifetime, there will also be plenty more. But nobody knows when stocks will fall. Those that guess correctly will try to guess again. This will cost them plenty. Instead of trying to time the market, we need know what we can control. That includes our behavior and our investment costs.
Maintain a globally diversified portfolio of low-cost index funds. If we’re working, we should add money every month, no matter what the markets do. Stock market crashes are especially good for young people. And they shouldn’t hurt retirees–if they can keep their cool.
Andrew Hallam is a Digital Nomad. He’s the author of the bestseller Millionaire Teacher and Millionaire Expat: How To Build Wealth Living Overseas
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