Correcting One Huge Mistake That Many Investors Make
April 25, 2016

Correcting One Huge Mistake That Many Investors Make

A beaming young girl handed me a couple of lamb skewers. Her father had cooked them over an open fire beside the river after her mother had marinated them. Another family skinned a small goat nearby. A voice from behind asked, “You want to take photo?”

Children sat giggling and eating on a tarp beside a fire. I took out my iPhone to snap a couple of pictures. That’s when I heard an urgent voice. “My friend, my friend, not the women!” I checked the picture I had taken. My image had also captured one of the women with her back turned to me. Sharp words can be teachers of cultural taboos.

I’m writing this from the Sultanate of Oman. Home to about 4 million people, it’s a wealthy country that borders Saudi Arabia, Yemen and the United Arab Emirates. I travel the world, giving investment talks to (mostly) U.S. expatriates. Every country I visit has its own cultural norms.

Sultanate of Oman Map
Sultanate of Oman - Google Maps

But I also notice norms among American investors. Many chase past performance, tilting their portfolios towards yesterday’s winning funds. Thirteen years ago, I started giving seminars to show expatriates how to build low cost portfolios of index funds or ETFs.

My lesson was simple. I recommended a U.S. stock index, an international stock index and a U.S. bond market index. Rebalance once a year to maintain a constant allocation.

I often bump into my seminars’ attendees, many years later. Too often, they let fear, market forecasts or greed shift their portfolios’ allocation.

It’s common among all investors. Morningstar proves it. The fund-rating agency determines how much a fund would have gained if an investor bought and held it. They then compare those results with how each fund’s typical investor did.

Vanguard’s S&P 500 index averaged a compound annual return of 6.89 percent per year during the 10-year period ending March 31, 2016. This figure includes reinvested dividends. But the average investor in the S&P 500 didn’t come close to earning that.

Below, you’ll see a 13-year performance chart of the S&P 500. Note how the index rose, without much interruption, between 2003 and 2007. Each year, as the index rose higher, more investors piled in. By 2008, stocks began to fall. Many investors bailed. In 2011, after the index had a couple of good years, many investors on the sidelines started to buy once again.

Vanguard’s S&P 500 gained an average of 6.89 percent per year during the 10 years ending March 31, 2016. But according to Morningstar, the typical investor in that fund averaged a compound return of just 4.52 percent per year. They preferred to buy on highs. They added less on lows.

S&P 500
March 31, 2003-March 31, 2016
S&P Results2003-206

Disciplined investors, who added an equal amount of money every month, would have averaged a return that exceeded 7.2 percent per year. Their money would have bought fewer units when the fund rose in price and more units when the fund became cheaper.

Unfortunately, most investors lacked the discipline to do that.

Can a financial advisor prevent investors from chasing their own tails? That depends. In December 2014, I checked the ten-year performances for investors in American Funds. Investors can’t buy these funds without a broker or a financial advisor.

In the U.S. Large Cap category, investors underperformed their funds by 1.37 percent per year. In the Emerging Markets category, investors underperformed by 3.34 percent per year. In the Broad International category, investors underperformed by 0.91 percent annually. Small Cap fund investors fell 1.41 percent behind per year. This suggests that advisors helped some, but not enough to capture the actual return of the fund.

But it’s when we do the math that the real cost of these failures shows up. If a portfolio’s funds average a compound annual return of 8 percent and an investor in those same funds averages 1.41 percent less, it can cost tens of thousands of dollars over an investment lifetime.

$10,000 Invested Annually For 30 Years

Annual Investment $10,000 $10,000
Number of Years 30 30
Compounded Annual Return 8% 6.59% (deducting 1.41% for silly investment behavior)
End Result $1,223,458 $935,553

Some may argue that many of those who sell American Funds are brokers, rather than Certified Financial Planners. Many brokers aren’t trained to build diversified portfolios and rebalance once a year.

But many Certified Financial Planners also speculate. I quoted one of Raymond James Financial Services’ Certified Financial Planners (CFP) in my book, The Global Expatriate’s Guide To Investing. She said, “Raymond James is the only firm in the industry to use forward looking capital market assumptions. The economic information is purchased from a third party firm called Mercer Investments.” In other words, Raymond James believes the firm they hire helps them strategically speculate which sectors or asset classes to purchase. I doubt that they’re the only firm that does that.

Personal finance columnist Jason Zweig, in his excellent book, Your Money And Your Brain figures such firms should be held to an ancient standard: “The ancient Scythians discouraged frivolous prophecies by burning to death any soothsayer whose predictions failed to come true…Investors might be better off if modern forms of divination like market forecasts and earnings projections were held to biblical standards of justice.”

Fortunately, investors have at least two solutions. They could buy Vanguard’s Target Retirement Funds or they could invest with a robo-advisory firm.

Vanguard’s Target Retirement Funds are fully diversified portfolios that are rolled into a single fund. Most investors in these funds dollar cost average–often through their employers’ 401(k). As such, these investors pay a lower than average price for their fund units over time. Instead of these investors underperforming their funds, they end up beating them.

Investors Beat Their Funds
10-Year Returns To March 31, 2016

Fund Annual Fund Performance Annual Investors’ Performance Annual Advantage
Target Retirement 2015 5.30% 5.42% +0.12%
Target Retirement 2025 5.37% 5.96% +0.59%
Target Retirement 2035 5.40% 6.47% +1.07%
Target Retirement 2045 5.48% 6.71% +1.23%

Investors with a robo-advisory firm could see much the same thing. In most cases, their assets would get rebalanced once a year. Such firms don’t usually alter portfolios based on economic forecasts (call and ask, just to be sure). This New York Times article lists many of America’s most popular robo-firms. Some offer more services than others.

Investors would pay slightly lower fees if they built portfolios of low cost index funds or ETFs on their own. But our demonstrated behavior proves that most of us shouldn’t.

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This article contains the opinions of the author but not necessarily the opinions of AssetBuilder Inc. The opinion of the author is subject to change without notice. All materials presented are compiled from sources believed to be reliable and current, but accuracy cannot be guaranteed. This article is distributed for educational purposes, and it is not to be construed as an offer, solicitation, recommendation, or endorsement of any particular security, product, or service.

Performance data shown represents past performance. Past performance is no guarantee of future results and current performance may be higher or lower than the performance shown.

AssetBuilder Inc. is an investment advisor registered with the Securities and Exchange Commission. Consider the investment objectives, risks, and expenses carefully before investing.