Carpe Diem

7 essential truths that most investors understand intellectually, but don’t accept emotionally despite empirical evidence

Below are seven essential truths that most investors understand intellectually, but frequently don’t accept, no matter how much empirical evidence they are presented with, from Josh Brown, CEO of Ritholtz Wealth Management (slightly shortened here):

1. Anyone can outperform at any time, no one can outperform all the time. There is no manager, strategy, hedge fund, mutual fund or method that always works. No one and nothing stays on top forever; the more time that passes, the more likely you are to see excess returns from a given style of investing dwindle.

Investors understand this truth intellectually, but they don’t accept it. See here and here.

2. Persistence of performance is nearly non-existent. Because there is absolutely zero correlation between a manager’s past or recent performance and what may happen in the future. The outperformers of last year are equally likely to outperform next year as they are to underperform, statistically speaking. You constantly hear about the few dozen managers who’ve beaten the odds and consistently outperformed, you hear almost nothing about the millions who’ve tried and failed.

Investors understand this truth intellectually, but they don’t accept it. See here and here.

3. Taxes and commissions matter. 99 percent of the people you will have market discussions with will refer to before-tax returns, and often they discuss investments gross of fees and commissions. The effects of these two constant costs cannot be overstated – they can reduce a strategy that looks fantastic on paper to a complete debacle and they frequently negate market edges and alpha once factored in.

Investors understand this truth intellectually, but they don’t accept it. See here.

4. Incentives matter. Everyone has to earn a living. Figure out how an investment management person gets paid and what drives their compensation and you can often work backwards to determine how their incentives may affect you. There’s nothing wrong with an advisor or a fund charging for their services, so long as the consumer understands that this will lead to certain biases and conflicts that are ever-present and ineradicable.

Investors understand this truth intellectually, but they don’t accept it. See here.

6. The crowd is always at its most wrong at the worst possible time. Over the long haul, only one thing is certain – there is no worse performing “asset class” than the average investor. In the aggregate, investors underperform value stocks, growth stocks, foreign stocks, bonds, real estate, the price of oil, the price of gold, and even the inflation rate itself. Nothing underperforms the investor class. On the whole, we bet big on assets that have already gone up a lot and sell out after they’ve gone down. We allocate heavily toward star managers just as their performance is about to revert to the mean – and we even pay up for the privilege. This is the eternal chase and it is as old as the hills.

Investors understand this truth intellectually, but they don’t accept it. See here and here.

7. Fear is significantly more powerful than greed. Behavioral science has proven that we feel anguish over losses much more acutely than we feel joy over gains. We are genetically hardwired to act quickly when we feel threatened – and this extends itself to our most precious modern resource, our money. That’s why markets drop much more quickly than they rise.

Investors understand this truth intellectually, but they don’t accept it. See here.

MP: Several of the essential truths above might help explain why 70% of US investors don’t own a single index fund as part of their investment portfolios, despite the overwhelming evidence of their superior performance over active funds over long periods of time? They understand that empirical evidence intellectually (as maybe do their investment advisers), but don’t accept it emotionally enough to act on that evidence?

HT: Warren Smith

15 thoughts on “7 essential truths that most investors understand intellectually, but don’t accept emotionally despite empirical evidence

  1. I’m assuming by the term “U.S. investors,” we are not talking about the almost 40% of workers who do not have $1000 in savings (according to EBRI). That leaves 60% left with investable funds.

    For the 70% of the 60% left who do not have an index fund, many of those investors feel they must beat the market, so if the market is 6% they want 10% (these are gamblers you probably can’t change). On the other end, you have many who will not or should not have anything to do with stocks at all because they can’t handle the drops and still sleep at night, so they need an investment choice where their savings does not widely fluctuate (these are people who get sick or even suicidal when the market drops).

    Of the possible 10-20% of the investors left of the total population, I think index funds should be a significant part of a properly diversified portfolio.

    • “I think index funds should be a significant part of a properly diversified portfolio.”

      Walt, don’t you mean low cost, highly liquid equity index funds?

      • CB, sure, low-cost is usually best. I am not aware of too many funds that are not highly liquid. I don’t see any particular advantage to ETFs you can trade at any time of the day in what should usually be a buy-and-hold, long-term strategy.

        With 40% of people not having $1000 in total savings, and the next 25% not having a 3-6 month emergency fund that should not be in the stock market, we might have bigger problems than people spending too much in active trader fees. I still agree that low-cost index mutual funds/ETFs are great for those who should be or wish to be in equities.

        • ” I am not aware of too many funds that are not highly liquid.” I thought this was the case also but…

          Walt and others, the current issue of Barron’s has a special section called “The New ETF Handbook”. In one article the author, Jonathon R. Laing, writes about the Flash Crash of May 2010.

          The overall U.S. market lost 10% in a half hour but ” some 20% of U.S. equity ETFs lost more than 50% of value before the snapback…” And, nearly 70% of all trades that were canceled were ETFs according to Morningstar — that’s illiquidity.

          The advice from Barron’s is : “Stick to ETFs representing broad, liquid parts of the market and offered by reputable companies”.

          • CB, Barron’s has great advice. There’s a lot of stuff to buy out there, and it is very easy to buy now. I don’t miss the old days calling my stock broker up and paying him a few hundred bucks to buy or sell for me.

            Most of my investments are either through Fidelity or Vanguard, and I don’t have any closed-end funds or exotic ETFs. It’s a good idea to “buyer beware” anything. I would not suggest making any trades in or out during a crash anyhow, but that’s just my personal opinion.

  2. these seem like poor metrics and a rigged game to try to prove a thesis that is not nearly so true as is being claimed.

    ” Anyone can outperform at any time, no one can outperform all the time.”

    this is irrelevant. what matters is out-performance OVER time.

    if the S+P does +5%, +5%, +5%, -20% in 4 consecutive years and a fund does +4%, +4%, +4%, +4%, it “underperformed” in 3 of 4 years. yet where would you rather have had your money?

    this is why point 2 is similarly bogus.

    it’s a meaningless metric designed to make managers fail.

    you do not have to win every year and there is no sane financial reason to focus on only managers that have never underperformed.

    if the S+P does 5, 5, 5, 10 and a manager does 5, 5 , 4, 20, he’s no longer in the group that never underperformed in a given year, but he HAS outperformed over time.

    these are simply not valid metrics.

    there are arguments to be made for indexing and there is, without question, a structural problem with successful active mutual find managers (they keep getting more assets until they cannot outperform anymore) but notion that you have to win ever year and that only a manger that has outperformed every year in the last 10 can be deemed to have outperformed the index are simply false.

    they have no basis in fact nor do they necessarily have any relationship to long term asset accumulation.

    further, as we have discussed before, it is active investing that determines index returns. the more indexers you have, the less efficient your capital markets become. money gets allocated based things other than the companies it’s going to. if everyone did it, we’d have no capital markets at all.

    i think we need to be a great deal more careful here in terms of just what is being measured and just how these practices interrelate to one another and to long term economic growth and index appreciation.

    • morganovich: “notion that you have to win ever year and that only a manger that has outperformed every year in the last 10 can be deemed to have outperformed the index are simply false.”

      I agree.

  3. Mark, I’m curious about this statement:

    “70% of US investors don’t own a single index fund as part of their investment portfolios”

    Would investors who own a low cost target retirement fund be included in that 70%?

    As I understand it, low cost target retirement funds, the ones which themselves only invest in passive index funds, are a popular choice for 401K investors. Many 401K investors have very little confidence in their ability to manage even a simple portfolio of 3 or 4 index funds. For them, the slightly higher expense ratio of the target retirement funds just might be a better choice than even a tiny portfolio of index funds which would require their attention.

    Please note that I am referring to “low cost” target retirement funds such as those offered by Vanguard. I believe the Vanguard Target Retirement 2030 fund (VTHRX) has an expense ratio of 0.17%, the same as the ratio for Vanguard’s S&P 500 Index Investor shares fund (VFINX).

  4. One of the most important things I learned in my finance class in grad school was that the only way to beat the market is to cheat. I have never trusted anyone with consistently fabulous returns.

  5. While I share a bias for index products as well , this post is completely missing the Forrest for the trees.
    Retirement readiness is – overwhelmingly – a function of the timing and amount of savings and withdrawals – and investment policy. The Active / Passive decision is chicken feet when you can see the big picture

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