Performance and Behavior – Part 1

Harry Truman once said, “The only thing new in the world is the history you don’t know.” This Yogi Berra-esque quote by the former president simply states the obvious. So how does this apply to the investing world?

For all the machinations that individual investors – and their investment “gurus” – go through trying to successfully time the market ups and downs or pick the hot stocks or mutual funds, there is one investing maxim that has stood the test of time: Investment performance means almost nothing in the long-term, investor behavior means almost everything.

To make this point, I would like to take you back in history some four decades, to a Friday the 13th in April of 1970. Does that date sound familiar? Apollo 13 is one of my favorite all-time movies. Perhaps you remember where you were when you heard about the difficulty our astronauts had encountered so many thousands of miles away that day. The fact that they returned home safely was at least providential – if not miraculous.

If you have an iPhone in your pocket, pull it out for a minute. It is estimated that this machine contains more computing power than existed on earth in 1950. When Apollo 13 blew up it destroyed the mainframe computer. The device you are holding in your hand is a million times smaller, a million times cheaper and a thousand times more powerful than all the computer power that was available to NASA on that fateful night. So what does this have to do with investing? More on that in a moment…

Let’s go back to my statement concerning performance versus behavior. Each year, Dalbar, Inc., a securities market research firm, publishes a Quantitative Analysis of Investor Behavior. Since 1994, Dalbar has been measuring the effects of investor decisions to buy, sell and switch into and out of mutual funds. Once the investor data is compiled, the return is compared to the S&P 500 Index, which of course is a proxy for the U.S. stock market. The difference in the returns of actual investors against the S&P 500 provides a good way to measure the effects of A) seeking superior investment performance through active means (ie, picking and timing), as compared to B) regulating for proper investor behavior by holding a super-diversified passive portfolio for the long term and letting the invisible hand of the free market do all the work. Over the years, these reports have shown again and again that the average investor earns less than mutual fund performance reports would suggest. Why is that? Simply put, humans are emotional beings that make emotional, sometimes rash decisions about their money.

Here is more history to make the point: Dalbar reported the average stock fund investor had an average annual return of 3.49% for the period beginning January 1, 1992 through December 31, 2011 versus the S&P 500 return of 7.81% per year. The average equity investor underperformed the S&P 500 by 4.32% for the past 20 years on an annualized basis. And here is a calculation you won’t be able to do in your head: If you had invested $100,000 in an S&P 500 Index fund on January 1, 1992, your account would have grown to just under $450,000 by the end of 2011 (This assumes tax-free growth in a retirement account). However, the average stock fund for actual investors’ $100,000 would have only grown to a little over $230,000 based on Dalbar’s behavioral research. How important is investor behavior? Shall we say doubly important.

Now, back to Apollo 13. What does it have to do with our conversation here? Optimism. No matter how optimistic we are about the future, we cannot be optimistic enough when it comes to the entrepreneurial commitment to excellence and the innovation that free markets spawn. In 42 years, we have gone from a rickety old space capsule (by comparison) to a small gadget that gives us the world at our fingertips. And by the way, the S&P 500 Index was at 87 on the day Apollo 13 exploded. I will say again – it was at 87. That is not a misprint. The day I wrote this article in early August, it stood at around 1400 – and that does not include the dividends paid over this four decade stretch. So we have experienced tremendous growth in the great companies in the supreme free market system of all of history. But this did not occur without setbacks. Since 1970, we’ve seen three years where markets dropped by more than 20% and 5 years where it dropped more than 10%. These down markets represent ample opportunities for investors to have behaved badly (i.e. panic and sell out at the bottom). But overall, the S&P is up about 1,440% since the day Americans held their collective breath for the safe return of our brave men.

As you can see from learning this new insight, the issue is not the market. Most everyone can make a financial plan work well with a market return on equities in their portfolio. The issue is behavior. How can investors behave in the right manner to assure financial success? This is where a real understanding of history comes in.

We have named our current monthly newsletter series “Wealth with Wisdom.” I prefer the following definition of wisdom: rational action under uncertainty. 1 There is perhaps no better metaphor in modern day life for uncertainly than the stock market. Over the next several months we will try and provide an installment of wisdom that will benefit you and those you care about as you seek the best ways to behave when it comes to your money.

“A wise man will hear and will increase learning; 
and a man of understanding shall attain unto wise counsel.” 
-King Solomon, Prov. 1:5

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