Why Investors Are Doomed to Fail
by A. Scott White, CFP®, ChFC, CLU
It is now official. According to Morningstar, in 2014 only about 13% of actively managed, large-company stock funds posted returns above those of the S&P 500. The S&P 500 gained 13.7% for the year including dividends, while the average actively managed large-cap stock fund rose 10.2%.1 So why should investors bother with all the research and pay a higher fee for an active manager when they can possibly end up with lower investment returns than they would by simply buying an index fund? That’s the conclusion advertisers in our darling financial media hope investors will reach: Give up on how on you’ve been investing and move your investments to one of our advertisers.
But underperforming against an index is nothing new. You see, 96% of the top fund managers fall into the bottom half of performance in a three-year period when compared to their peers.2 So, not only do the best managers underperform when compared to an index, but they also underperform half their peers. It is easy for one to understand why investors may begin to question what once was thought to be a great investment. And then investors read financial articles and see advertisements about how this investment or that investment beat its peers over the past three years. And investors begin to wonder, “How good can any investment be if it cannot even keep up with its peers over a three-year period of time?” Investors may start to compare their investment returns to an index. And this is why they become doomed to failure. You see, in one- and three-year periods, active managers often underperform compared to an index. But what most investors don’t know is that over rolling 10-year periods, 85% of active managers have outperformed passive funds on both a total return and risk adjusted basis.3 Since investors may not be equipped to think in long term timeframes, often they compare their short term investment returns to an index’s returns—and that can lead to poor investor behavior.
“Fool me once, shame on you; fool me twice, shame on me; fool me three times….” you can fill in the rest. The point is that we humans are hardwired not to be wrong three times in a row. So even though it is quite common for the best fund managers to underperform against an index for three years and beat the index over 10 years, many times investors will not stick out the three years of underperformance to reach the 10 years of outperformance. It is not uncommon to see investors sell out of a manager in the third year of underperformance and buy a manager who has just finished their third year of outperformance— just in time for the investor to experience the new manager’s three-year period of underperformance.
To validate that those investors’ behavior had more to do with determining their performance than with the funds they actually invested in, we only need to look at this fact: Over the past decade the average equity mutual fund gained an average of 7.3%, while the average equity investor had 4.8% return.4
As long as people make their most important decisions in life based on emotions, and fear and greed remain the dominant investor emotions, then Wall Street advertisers should not have any problem motivating investors to continue to sell their “dogs” and buy the “good stuff.” If investors really want to improve their probability of increasing their investment returns, then perhaps they should turn off the financial news on TV, put down the investor periodicals, and find a qualified financial advisor who can help them cope through the emotions of holding quality funds in a diversified portfolio over long periods of time.
1Wall Street Journal, January 6, 2015 “Behind a Bad Year for Active Managers” by Tom Lauricella
2Davis Advisors. 190 managers from eVestment Alliance’s large cap universe whose 10-year average annualized performance ranked in the top quartile from January 1, 2002–December 31, 2011
3Morningstar Direct. For purposes of this analysis, all share classes used (active and passive/index funds), excluding load-waived classes, are in the Large Blend Morningstar category for the rolling 10 year periods from 7/1/1994 to 9/30/2014. Comparisons of other fund categories may produce different results
4Morningstar: Russell Kinnel, Director of Mutual Fund Research, “Mind the Gap 2014” February 27, 2014
The information contained in this report does not purport to e a complete description of the securities markets or developments referred to in this material. The information has been obtained from sources considered to be reliable, but we do not guarantee that the foregoing materials are accurate and complete. Any opinions are those of Scott White Advisors and not necessarily those of RJFS or Raymond James. Expressions of opinion are as of this date subject to change without notice. Past performance may not be indicative of future results. Any information is not a complete summary or statement of all available data necessary for making an investment decision and does not constitute a recommendation. Strategies discussed may not be suitable for all investors. Investing involves risk and investors may incur a profit or loss regardless of strategy selected. Diversification does not ensure a profit or guarantee against a loss. Commodities and currencies investing are generally considered speculative because of the significant potential for investment loss.Their markets are likely to be volatile and there may be sharp price fluctuations even during periods when prices overall are rising.