Home Radio Segments Steve's Market Commentary In 2017, Small Investors Underperformed Once Again: Here’s Why

In 2017, Small Investors Underperformed Once Again: Here’s Why

Steve Pomeranz, Beat The Market

Today, I plan to tell you a true story, and I want you to bear with me, and hear it out because there is a moral at the end of it, along with vital lessons for individual investors on how to grow your wealth.  So here’s the story:

Buffett Bets Against Hedge Funds

Warren Buffett strongly believes that active money managers, even the smartest of them, can almost never consistently beat the market, year after year.  With this strong belief, in 2007, Buffett challenged professionals in the hedge fund industry to accept the following bet:

“Over a ten-year period commencing on January 1, 2008 and ending on December 31, 2017, the S&P 500 will outperform a portfolio of funds of hedge funds, when performance is measured on a basis net of fees, costs, and expenses.”

Buffett’s bet was posted on a website called Long Bets, and can still be seen there today.  I’ve posted a link to it on my website.  Long Bets, by the way, was sponsored by Jeff Bezos, the founder and CEO of Amazon.com and it’s about people making long-term bets on what the future holds.

After posting the bet, as Buffett wrote on page 21 of his 2016 letter to Berkshire Hathaway shareholders,

“I then sat back and waited expectantly for a parade of fund managers …to come forth and defend their occupation.  After all, these managers urged others to bet billions on their abilities.  Why should they fear putting a little of their own money on the line?”

Then, only one man, Ted Seides, stepped up to Buffett’s challenge.  Ted was a co-manager of Protégé Partners, which invested in multiple hedge funds.  For his side of the bet, Ted picked five fund-of-funds whose results were to be averaged and compared against Buffett’s Vanguard S&P index fund.  The five funds Ted selected had invested their money in more than 100 hedge funds, which meant that the overall performance of the funds-of-funds would not be distorted by the good or poor results of a single manager.

Ten years later, on December 31, 2017, a million dollars invested in Ted Seides’ hedge funds would have gained $220,000, but a million invested in the S&P 500 index fund would have earned $854,000.  The low-fee passive investment that Buffett selected far outperformed active management by some of the brightest guys on Wall Street.

That’s the true story that I wanted to share with you, and its moral is simple—and this is the point I want you to understand the most:

If bright, financially-trained hedge fund managers cannot beat the market, can untrained individual investors fare any better?

The answer is a resounding NO.

And this answer is confirmed by a recent 2018 report titled the Quantitative Analysis of Investor Behavior by Dalbar, an unbiased evaluator of investment performance.  The report showed that individual investors again significantly underperformed the market in 2017.

I read the details on Dalbar’s report in a MarketWatch article by Lance Robert and want to share its key findings with you because today—with widespread access to the Internet—a lot of Americans are active investors in the stock market and end up underperforming the market or, worse, losing money year after year.

I want this self-destructive behavior to stop. So I urge you to listen in on how and why individuals make terrible investors, for the most part.

Dalbar’s 2017 Report Card For Individual Investors

As the Dalbar report notes:

  • The average equity mutual-fund investor underperformed the S&P 500 Index by a margin of 4.7%. Imagine the amount of potential loss of earnings when you compound that difference over a lifetime.
  • Now here’s something that’s directly related to investor psychology and behavior: equity fund retention rates decreased from 4.1 years to 3.8 years. What this means is that investors sold their equity fund positions much sooner in 2017.  Despite the drumbeat of buy-and-hold, investors couldn’t stay invested, on average, for more than 3.8 years.

As the Dalbar study notes, and I quote, “Retention rate data strongly suggests that investors lack the patience and long-term vision to stay invested in any one fund for much more than four years.  Jumping into and out of investments every few years is not a prudent strategy because investors are simply unable to correctly time when to make such moves.”

Looking at this from a longer-term perspective, over the past 20 years, the average underperformance resulted in a gap of 2.89%.  To put it in perspective, that gap would have resulted in $190,000 less earnings had you invested $100,000.

Why the underperformance? It is directly connected to the psychological behavior of individual investors, who allow their emotions and irrational reactions to rule their decision–making.

Why Individuals Underperform The Market

According to the Dalbar report, individual investors chronically underperform benchmarks for three main reasons: 1) psychological factors; 2) the lack of capital to invest; 3) withdrawing capital from our investments for other purposes.

Irrational behavioral or psychological biases that work against us are:

1. Loss Aversion—which is basically the fear of loss, which drives us to sell at the worst possible time, such as panic selling when markets are tanking.

2. Herding—where we blindly follow what everyone else is doing, causing us to sell low when markets are tanking and buy high when there’s a sense of euphoria and markets are rising. So we end up doing the exact opposite of that simple mantra of buy-low/sell-high!

3. Anchoring—which makes us emotionally attached to past events and keeps us from adapting to a changing market.

4. Regret—which leads to inaction because of the regret related to past investing mistakes.  Regret can be a rather nasty trap for investors.

5. Euphoria—such as the dot-com cycle that caused investors to turn a blind eye from the importance of basic business metrics, forgetting revenue and earnings per share and a host of other important data, only to be rudely brought back to reality when the bubble burst.

I met with a woman the other day, who said she got caught in the dot-com bubble and was just breaking even with the same stocks she owned in 2000. That’s 18 years of investing only to break even! What a waste and an example of irrational behavior!

6. Lack of diversification—which I see pretty often in my interactions with clients, who believe they have well-diversified portfolios when what they really have are investments that have a high correlation with each other and will react in similar ways in up and down cycles.  True diversification is a pretty complex thing, and this is one that you should consult an expert on so you aren’t double-whammyed when markets tank.

7. Media Influence—where investors tune in to the financial news every day, hang on every word that pundits spout, and get excited into buying or selling for no rational reason, racking up trading commissions, causing unnecessary turnover in their portfolios, and reducing fund retention rates.

The truly destructive part of our biases is that they do not act independently but co-exist simultaneously, such as herding, loss aversion, and media influence all influencing us at the same time and compounding our investment mistakes.

Can We Beat The Market?

So, are we all doomed to underperform the market?  Alas, for the most of us, I do believe the answer is a resounding YES!—because try as we may, it’s really hard for most of us to shake off our hard-wired emotions and behavioral biases.

That said, there is a faint glimmer of hope, but only for those who set up and follow a strict investment discipline, unhinged from their emotions in good times and bad.  For the rest of us, I do believe it’s best to outsource the job of money management to a fiduciary advisor who is obligated to do what is in your best interest and is emotionally disconnected from the money s/he manages for you.  Even then, don’t count on beating the market—and consider yourself really lucky if your portfolio’s performance almost matches Mr. Market.

The Steve Pomeranz Show and United Capital Financial Advisers, LLC are separate and unrelated companies. Investing involves risk and investors should carefully consider their own investment objectives and never rely on any single chart, graph, or marketing piece to make decisions. The information contained herein is intended for information purposes only, is not a recommendation to buy or sell any securities, and should not be considered investment advice. Please contact your financial advisor with questions about your specific needs and circumstances. There are no investment strategies, including diversification, that guarantee a profit or protect against loss. Past performance doesn’t guarantee future results. Equity investing involves market risk, including possible loss of principal. All information quoted in this piece is for informational purposes only, and the author does not warrant the accuracy, completeness, timeliness, or any other characteristic of the information. All information and data are driven from publicly available information and has not been independently verified by the author.