Anyone with even a passing interest in investing has heard it before – the average investor consistently and significantly underperforms every other asset class, from the S&P 500 Index and bonds, to gold, oil and real estate, while barely outpacing inflation. (Don’t believe it? Just look it up.) And anyone who has heard this or worse, experienced it for themselves, has probably asked the question: why is it that investors fail? What prevents them from doing at least as well as the index, if not topping it? Where are they going wrong? Well, imagine being that average investor for a minute. We’ll call her Deidre. She’s a lot like you probably. Doing what she thinks she’s supposed to be doing. She finishes school, gets a job, puts a down payment on a house, has a couple of kids and tries when she can to tuck away a little money for a rainy day. As you surely know, making money has never been an easy venture for the majority of people, Deidre included. You toil away for 30, 40, 50 years or more just to have enough to support yourself and your family and hopefully have enough left over to retire on. What’s not as universally acknowledged is that making money in the stock market is no less difficult. In part because you need a proprietary insight into why an investment will be bigger in the future. In other words, what do you know about a business that others don’t? Unless you have a relatively unique idea that isn’t widely recognized or that the rest of the market doesn’t fully appreciate, you’re destined to mediocrity. Deidre’s first blunder is that she isn’t aware of the relationship (or lack thereof) between a business’s true value and its stock price. She invests in that tech company because she sees how popular its gadgets are with her son and his friends. Not because she knows anything about how the business is run. On that front, she’s completely in the dark. Her situation only goes downhill from there. Because investors are susceptible to another self-perpetuating hurdle that stops them from realizing investment success – namely, their own emotions. To make it as an investor you need proprietary insights plus, to take a page from that famous Kenny Rogers tune, “You’ve got to know when to hold ‘em. Know when to fold ‘em. Know when to walk away. And know when to run.” Investors are notoriously bad at all of these things. Deidre is in the same boat. She buys stocks on exuberance based on some piece of good news or when a so-called trusted friend gives her a hot tip along with the reassurance that it’s a guaranteed win. She sells stocks when she’s scared, when fear dominates the market or after she opens her account statement and doesn’t like what she sees. No one is thrilled when their investments drop in value, including Deidre. So she acts on her doubts and anxieties or excitement and greed about what’s happening in the short term, in effect buying high and selling low, precisely the opposite of how investors should behave. But Deidre can’t bear the brunt of 100% of the blame, nor can her counterparts. Unfortunately, an entire industry has degenerated over time and is now designed to be complicit in separating investors from their hard-earned savings. Consider how the definition of “long term” has changed to the point where today, it doesn’t count for being a very long time at all. If you think anything less than a 10-year investment horizon is still long term, you’re kidding yourself. Although you’d be in good company. The ones who should know better – the titans of the investment industry – are just as guilty of living in the here and now, unable to look beyond their next bonus cheque. Companies close poorly performing funds (or those that simply aren’t bringing in enough money) in a heartbeat. Maybe you won’t notice or don’t care that at some time in the not-so-distant past they were aggressively peddling those same funds to the public. As for the people behind the products, the average portfolio manager is rarely around for more than a decade, especially if they suffer a bout of continued underperformance relative to the benchmark they’re measured against. The people they answer to, like their bosses, company shareholders and end investors don’t have the staying power, confidence or fortitude to support them through these periods as increasing amounts of money flees their funds. So they get fi red. Or they move on to greener pastures under the lure of higher incomes or similarly attractive incentives. There are other ways investment firms don’t seem to have their priorities straight. For one, they tend to ask “will it sell?” instead of “should we be selling it?” Hence the plethora of flavour-of-the-day offerings that surface depending on the current investing climate. Market volatility on the rise? Here come the promises of low-volatility funds. Investors seeking yield? Say hello to a bunch of professed high-income-generating investments. Commodities or emerging markets shooting the lights out? Unveil products poised to take advantage of this awesome opportunity [insert appropriate number of exclamation marks here]. This is the modus operandi of marketing-led investment firms – drum up interest in stuff created to turn a profit, whether or not it’s in the best interests of investors. And charge as much as you can for it. After all, that expensive halftime commercial won’t pay for itself! Here’s another reason why investors like Deidre have trouble gaining any ground. Big investment costs erode their returns. Think of it as negative compounding. The longer Deidre is invested, the more she doles out in fees, which can add up to a substantial amount that, in some cases, can grow to be almost as much as her original investment. Not only does she need to find a quality investment to commit her savings to, she also needs to assess whether it’s worth the money she’s going to spend on it. That means being attuned to the fact that there are lots of funds out there that claim to be actively managed and charge higher fees as a result when, on closer look, they’re nothing more than index funds in disguise. Talk about a rip-off! Besides overcharging investors, these closet indexers suffer from diworsification, as does Deidre’s overall portfolio – a common problem plaguing investors. They own everything under the sun in the hopes that this will help them to make money and protect them against losses. Because when one holding isn’t doing well another will be, thus balancing things out. Said differently, accepting losses is part and parcel of the traditional diversification strategy. Doesn’t make a whole lot of sense, does it? Deidre and others like her have fallen into the overdiversification trap, inadvertently complicating their financial lives and getting stuck with higher transaction costs, more risk, adverse tax consequences and diluted portfolios that will get them nowhere. Even when she throws up her hands and enlists the “help” of a financial advisor, she takes a wrong turn. She doesn’t research his qualifications or capabilities. He coaches her son’s hockey team and seems like a nice guy. She takes him at his word. What she doesn’t know is that he makes product recommendations to her based on which fund company treats him to the best perks. Free fancy dinners, concert tickets, trips – these are what guide his investment decisions. Needless to say, he’s far from the top tier of his profession. It’s the blind leading the blind. This is scarcely a glimpse into the hurdles Deidre and investors like her face. On the whole, it really doesn’t look like they stand a chance. Between their own missteps and an industry that seems more their enemy than friend, they’re in a bad spot. If they keep it simple by partnering with a skilled and principled advisor and investment-led fund companies, committing to a long-term financial plan and building a portfolio that matches their goals, they greatly increase their odds of finding success. Demanding but doable. Otherwise, when you read back to the endless obstacles in investors’ way, you understand the frustration while being reminded that nothing worthwhile in this life comes easy. Investing is no exception. Among other things, it takes hard work, patience, a knack for the job, the right temperament and strong emotional control, discipline, the humility to recognize when you’ve made a mistake and quickly learn from it, the ability to think long term, passion and a heck of a lot of effort. Every time the market shoots up or takes a plunge, every time the media noise floods in, every time you question yourself, every time you’re kept up at night wondering about the future and whether you’ll ever be able to afford it, you put yourself in danger of falling off the wagon, so to speak. Investing will never be a cakewalk.
THAT’S WHY.*
*Not intended to be a vision test. The above was entirely inspired by Covenant House’s “Get a Life” campaign. Covenant House provides street kids with food, shelter, counselling, education and work skill so they can move from the street to a better life. We urge you to donate today at covenanthouse.ca.
